Companies including Microsoft Corp., Oracle Corp. and Home Depot Inc. have opposed reporting the costs in earnings, saying the options are difficult to value because many never turn into shares.
Complaints about this "difficulty" are quite common. IMHO this complaint is a red herring. On option exchanges, each option is valued maybe thousands of times a day on the average. And companies have "difficulty" doing it once a year? (S&P has said they want FASB 123 option expenses quarterly too. They may get it.)
From a cynical viewpoint, valuing option expenses may actually be "difficult". Management and accountants have to decide how much they can stretch the truth.
Examples:
(01b) Companies can choose an "expected life" shorter than the expiration term (life) of an employee stock option. CSCO FY01 estimated an expected life of 3.1 years. The options have an average exercise price of $39.93 versus $15.73 today .. and 3.1 years may be much too short.
These options have a vesting schedule of 20% after the 1st year, another 20% after the 2nd year, etc. ... to eventually reach 100% vesting after 5 years. So CSCO is saying they expect the average option share to be exercised 6 months after vesting.
Much more to the point: These options have a 9-year life (could be shorter, says "no later than 9 yrs"). I am not aware of 9-month options on the open market being priced like 3-month options. Whether the option will be exercised after 3 years, after 5 years, or never has no bearing on the value of the option on the grant date. IMHO the value should be based on the true life of the option, 9 yrs in this case.
How much difference does it make you ask? *Using a 9-yr life vs a 3.1 yr life would increase expenses about 75% for CSCO FY01*. BACKUP: Using CSCO's volatility = 34.8%, risk-free interest rate = 5.4%, exercise price = market price = $40, and a Black-Sholes option model, I calculate $21.64 per share for 9-yr, and $12.22 for 3.1 yr. CAVEAT: CSCO reported $13.31 .. maybe because my option calculator doesn't know how to deal with a vesting schedule. Something's slightly off though .. including effects of the vesting schedule should reduce the option value .. not increase it. Oh well, close enough.
(010b) The next assumption management can play with is volatility .. which is more difficult to assess than option life.
A historical 5-yr average volatility for CSCO's stock price would be appropriate here, but I can't find my link. If anyone has a link, would you provide it please?
The implied volatility today for calls on pcquote.com range from 51% to 82% (~65% ave) versus CSCO's 34.8%.
A 34.8% volatility definitely yields an option expense lower than 65%. By how much you ask again? With other inputs being CSCO's number, for 3.1 yrs my calculator says $12.22 for 34.8% and $19.17 for 65%. (See the previous caveat.) *Using a volatility of 65% versus 34.8% would increase option expenses 55% for CSCO FY01.*
*Combine the effects of using 9-year life (instead of 3.1 yr) and 65% volatility (instead of 34.8%), and the option expense would be 170% higher than CSCO reported.* THIS IS A BIG DEAL IMHO.
Since I own CSCO and other tech stocks, I actually hope I'm wrong on this. And I may well be, since this is my first look at de tails of option expenses. Also allow me a pet peeve please. A volatility number is volatile. Volatility is a guestimate. Why would a corporation report it to 3 places .. three .. four .. point .. eight? Are they trying to imply that it is an accurate, unquestionable number?
(011b) As you most likely noted from the above, a risk-free interest rate must also be assumed for the Black-Sholes eq'n. CSCO FY01 used 5.4% which seems reasonable to me. Many many people in the world are acutely aware of interest rates, so numbers here should be "right on", or at least as good as anybody else can guestimate.
(0100b) The other inputs to B-S are exercise price and fair market value (market price) on the grant date. There are no opportunities for games here.
*The Article: "When Options Count, Profit Slump Widens: Taking Stock ([edit: Update010b])" by Perri Colley McKinney and Rob Urban is well written. They presented the facts without inserting opinion (unlike me) and really seem to know what they are talking about. Do you happen to have a link to "Update01b"? Thanks.
JMHO, but based on fact to the best of my knowledge.
Ron |
