Challenges for Companies in Valuing Options: As companies face the prospect of having to expense the cost of employee stock options, it’s important for them to understand the ins and outs of option pricing.

In the wake of the recent accounting scandals, there has been a lot of talk about employee stock options, largely centered on whether companies should expense them. Proponents of the expensing of stock options are pushing for a uniform accounting treatment for options, saying that they are a compensation expense which should be reflected in companies’ financial reports. Less discussed has been the issue of how much employee stock options are actually worth. Assessing the fair market value of options can help companies understand the impact that the options expense has on earnings, and figure the true cost of employees’ compensation packages. For companies being primed for an IPO, careful options pricing allows firms to manage post-IPO compensation levels. At the moment, accounting rules do not require companies to show the impact that stock options have on their earnings; they need only cite the information in footnotes in their annual reports. Companies currently have two choices in accounting for employee stock options: The Accounting Standards Board’s Opinion No. 25 (APB 25) generally provides for the non-recognition of expense for grants of stock options with fixed terms. Whenever APB 25 accounting is not allowed, the Financial Accounting Standards Board’s Statement 123 (FASB 123) requires expense recognition for the fair market value of the option on the grant date, spread over the vesting period. Despite the FASB’s push to have firms follow FASB 123, most companies have continued to follow APB 25 because it doesn’t require them to expense employee stock options, says Steve Rimmer of PricewaterhouseCoopers. Cash-strapped technology concerns have been especially resistant to adopting FASB 123 because they have relied heavily on options as an incentive to attract and retain top talent. If they had been required to expense options, their earnings most likely would have been significantly reduced. Amazon.com and Computer Associates International Inc. are currently the only technology companies that have decided to begin expensing options. But it appears that APB 25’s days may be numbered. In response to investors’ demands for greater transparency in corporate earnings reports – fueled by the recent accounting scandals – a number of corporate giants have announced that they will begin expensing the cost of stock options. Coca-Cola Co., General Electric Co., Wal-Mart Stores Inc., Home Depot Inc., United Parcel Service Inc., and General Motors Co. are among those that will utilize the FASB 123 method of accounting for options. It’s very likely, the experts say, that accounting rules will soon change, forcing all firms to follow suit. As the trend toward expensing options gains momentum, and the demise of APB 25 seems likely, the issue of employee stock option pricing becomes even more important, valuation pros state. Not only is it important for companies to understand the expense of options and their impact on earnings but companies should also determine the value of the options in the context of employees’ compensation package, to ascertain whether workers are being overcompensated or undercompensated. Under the current option pricing models, companies could undervalue or overvalue the options and end up expensing an amount that is more or less than what would be considered the fair market value of the options, notes Rimmer. They could also be overpaying or underpaying employees for performance. Some valuation professionals think that the Black-Scholes model, the preferred method for valuing options, overstates option value because it doesn’t take into account the options’ lack of marketability. Black-Scholes, experts note, was designed for short-term options, which expire in a couple of months, and tradable options, which can be bought and sold. Valuations of employee stock options can be complex because the options are neither short-term nor marketable. They often cannot be exercised for a number of years, and even if they are exercised, many employees are only allowed to sell the stock during limited time frames. Additionally, employees who are granted options may have to forfeit them if they leave the firm before their options have vested or if they quit at a time when the stock price is lower than the option exercise price. “Black-Scholes is fine for publicly traded options but inappropriate for employee stock options,” says Alfred King, Vice Chairman of Valuation Research Corp. “The fair value of an option that you can’t trade must be less than one you can buy or sell.” King, who has worked on numerous assignments involving option valuations for gift and estate tax purposes, asserts that most option values should be cut by more than 50%. He says that he and many appraisal professionals recommend an approach in which discounts for the lack of marketability and for restrictions be applied to the Black-Scholes method. And once companies “face up to charging options to expense,” they will want to apply these discounts, predicts King. Also noting drawbacks to the Black-Scholes method are companies such as Wal-Mart and Commerce Bancorp Inc. In recent annual reports the firms have stated that because employee stock options are characteristically different than tradable options and since option valuation methods require the input of highly subjective assumptions which can significantly affect the valuation calculations, the pricing models that are currently available to companies do not provide an accurate gauge of the fair value of employee stock options. While Lorre Jay, a Senior Vice President at Houlihan Lokey Howard & Zukin, acknowledges that Black-Scholes may not fully take into consideration marketability in its formula, she adds, “It’s unclear to me to what extent there is a lack of marketability imbedded in the formula, but that is probably an issue that needs to be addressed. I would question whether or not the model overvalues options because of that.” At a recent Appraisal Issues Task Force meeting held in Philadelphia, the topic of applying “lack of marketability” discounts to the Black-Scholes model was raised by various appraisal experts, and a representative from the SEC who attended the meeting said that his organization would discuss the issue, says King. As part of its move to begin expensing options, Coca-Cola plans to use quotations from independent financial firms to ascertain the fair value of the stock options it grants. The soft-drink maker has said that the option value to be expensed will be based on the average of the quotes received from the financial institutions to buy or sell Coca-Cola stock under the “identical terms of the stock options granted.” Commenting on Coca-Cola’s intentions, Tim Pecaro, a Principal at Bond & Pecaro, states: “The company is basically saying that they don’t think that Black-Scholes is the right way to value options. What they are talking about is working with investment banks to create a fictional market for their options. For financial reporting pur- poses, they would consult with these bankers to find out what the value of the options is by determining what the fictional marketplace would value the options at.” Another method that could be used for options valuation is the Binomial Approximation pricing method. Binomial Approximation, most often used for tradable options, is based on a sequence of probabilities relating to stock price movement. At each step on this recombining tree model, it is assumed that the stock price will increase or decrease by an amount calculated using volatility and other input factors. The tree outlines all of the possible paths that the stock price could take during the life of the option. However, the several pricing models that are available yield values in a similar range, says King. “You can’t play around by using Binomial versus Black-Scholes – it’s only pennies per option difference.” The Black-Scholes formula may not be a perfect method for pricing options but it does provide a fair approximation of option value, and is the most commonly used method, experts note. King estimates that roughly 90% of companies use this formula. Black-Scholes, which primarily focuses on stock price volatility and the amount of time to the option’s expiration, also takes into consideration the stock price on the grant date, the exercise price, the dividend yield, and the risk-free interest rate. Volatility, the experts say, is one of the most critical inputs for determining the fair market value of an option. What makes the pricing so difficult is that option valuation methods require the input of subjective assumptions, including the expected stock price volatility. “Black-Scholes has problems in that it was written in a theoretical way and it assumes things that exist in a vacuum that don’t necessarily exist in the real world, such as that the company can borrow and lend at the same rate of interest and that stock price volatility cannot be accurately estimated. Therefore, people may tend to modify it for their purposes,” says Jay. She adds that stock price volatility can be reasonably estimated, but that the Black-Scholes model is very sensitive to the inputs. “You have to make sure that your inputs are reasonable and consistent. If you are wrong in your estimate, you will end up with a different volatility indicator depending on what assumptions you decided to use, and that could dramatically change the option value.” It can be especially difficult to value options granted by private or closely held companies using the Black-Scholes method, says Pecaro, whose Washington, D.C.-based firm provides valuation, financial, and strategic consulting services to media, telecommunication, and Internet companies. Since the formula is very sensitive to the inputs, the value can fluctuate significantly depending on what inputs are used. “Unlike a public company that has some established benchmarks through its own stock trading, private and closely held companies don’t have those benchmarks, so some of the inputs may be difficult to arrive at,” he says. Another valuation issue involving private companies is options pricing for a company anticipating an IPO. The valuation can be tricky, says Jay, because in addition to economic factors – such as expected earnings of the newly public company – that need to be considered, there are factors that are hard to gauge, such as market interest in the company, the company’s growth prospects, supply and demand for other IPOs in the same sector, and even how the investment bank marketed the IPO, she states. She adds that the SEC closely monitors the values at which a company grants stock options to employees close to the IPO date and scrutinizes the method the company uses to set the exercise prices for the options to make sure that the company has not issued “cheap” stock – issued stock at prices that are below the stock’s true value. If the SEC suspects that the options were not priced at the fair market value at the grant date, it will require the company to record a compensation expense for the “discount” in the options, experts say. If this happens, the IPO could be delayed, as the SEC and company debate the proper valuation, and the company’s financials could be altered, which might cloud investor’s views of the company and the impending offering, they add. While there are many issues to consider in pricing options, the one that vexes Jay the most is potential dilution created when the options are exercised and become full-fledged shares that are traded on the stock market. The mixing of these “new’ shares with existing shares could depress a company’s stock price, she says. “What happens is that all of the shareholders get diluted ultimately when the options are exercisable. The company may have issued them for pennies 10 years ago and now the individuals owning them may be able to exercise them and take away more than their pro rata share of ownership, i.e., earnings, because they have been given this chunk of stock. So, it’s dilutive to the shareholders and was unclear at the time that the company granted the options just what that dilution would be.”