Valuing Employee Stock Options WHAT THE EXPERTS ARE SAYING ABOUT BLACK-SCHOLES...
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"Moreover, it seems unreasonable to estimate the value of the options given the obvious fact that the option has absolutely no intrinsic value on the day it is received. Also, though the Black-Scholes model is well tested for publicly traded options, valuing private, long-term, non-transferable options with significant restrictions seems much harder and imprecise at best." -William Sahlman, Harvard Business School, July 24, 2002. "As a result of these differences, an employee option must be worth less than an option of the type that Black-Scholes was meant to value. So any result obtained by using this method would need a "haircut" or a discount to a lower figure. "Nobody knows how much of a haircut to take and nobody will probably ever know." -William Margrabe, Ph.D. from University of Chicago and who was Fischer Black's research assistant, Bloomberg, July 23, 2002. "According to experts, the Black-Scholes options pricing model is not designed to deal with options having the characteristics of those granted to employees, so the initial value will not even represent an accurate starting point." -James DeLong, Senior Fellow, Project on Technology and Innovation, Competitive Enterprise Institute, CEI C:\SPIN, Stock Options: `For God's Sake-Turn This Herd!' July 19, 2002.
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"Because employee stock options have durations of five to 10 years, are complicated by not vesting immediately, are contingent on continued employment and subject to various restrictions, it is virtually impossible to put a precise estimate on the option's value. Moreover, employee options cannot be sold, violating one of the key Black-Scholes assumptions." -Burton G. Malkiel, Professor of Economics, Princeton University, and William J. Baumol, Professor of Economics, New York University, "Stock Options Keep the Economy Afloat," The Wall Street Journal, April 4, 2002. "The Nobel Prize winning Black-Scholes model does an excellent job of predicting the prices at which short-term options trade in the market. But the Black-Scholes formula does not provide reliable estimates for longer-term options, such as those lasting six months to one year, and market prices often differ substantially from predicted values." -Burton G. Malkiel, Professor of Economics, Princeton University, and William J. Baumol, Professor of Economics, New York University, "Stock Options Keep the Economy Afloat," The Wall Street Journal, April 4, 2002. WHAT THE COMPANIES ARE SAYING ABOUT BLACK-SCHOLES... "Dennis Powell, Cisco's controller, said the company continues to believe stock options shouldn't be expensed, because they can't be fairly valued. For example, the options Cisco granted for the fiscal year ended July 2001 were valued at $3.3 billion. Today, using the same statistical model, those options would be valued at $131 million, because Cisco's stock price has dropped precipitously, Mr. Powell said." -Dennis Powell, Controller, Cisco, as quoted by Scott Thurm in "Cisco Says Expensing Options Would Reduce Its Net by 80%," The Wall Street Journal, September 19, 2002.
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"The biggest concern of the HP board and management team is that there are no clear accounting rules on how to value the expense of options consistently across companies. Until there is clear accounting guidance and the rules have been established, it is our belief that reporting results that include options expense adds complexity and confusion to evaluating business performance." -Carly Fiorina, Chief Executive Officer, Hewlett-Packard, "HP says it's making earnings goals," The San Francisco Chronicle, August 28, 2002. "[Procter & Gamble] has concerns about the use of the Black-Scholes model, which is currently broadly used to value employee stock options. This model was designed to value short duration exchange traded options. Employee stock options, which have a longer term and are not transferable, are also subject to forfeiture by the employee, and therefore represent a very different kind of financial instrument. As such, Black-Scholes can provide misleading results when applied to employee stock options. It is on this basis that the Company does not include the expense in profit reporting at this time. In summary, the Company encourages the accounting profession to act promptly, and bring resolution to this issue. An important element of this will be identifying a better tool for measuring the cost." -Statement of Procter & Gamble," Global News: Expensing Stock Options," August 29, 2002. "We believe that the Black-Scholes option pricing model, while a useful tool for the pricing of short-term freely tradable options (the purpose for which it was developed), is severely flawed in valuing the long-term, illiquid employee options." -John F. Gifford, Chairman, President and Chief Executive Officer, Maxim Integrated Products, Inc., August 13, 2002 press release.
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"Costco intends...to continue to examine option valuation methods that will yield a more appropriate measure of the value received by employees through option grants. It also will urge the FASB to adopt accounting standards that employ techniques better adapted than Black-Scholes to valuing employee stock options." -Costco Wholesale Corporation, August 14, 2002 press release. WHAT THE EXPERTS ARE SAYING ABOUT VALUATION... "[C]urrent accounting rules already require the disclosure of enough data on options to allow the investor community to assess both their dilutive and their positive incentive effects on a company's stock...[T]he expensing of options poses formidable technical challenges. A cash compensation package has a certain value whose effect on corporate earnings is certain. The value of a stock option plan depends on the plan's vesting and exercising periods, the volatility of the underlying stock price over the life of the option plan, and the timing of decisions to exercise their options. So requiring the expensing of options could have the unintended effect of making corporate financial statements more misleading." -Laura D'Andrea Tyson, Dean, London School of Business, and former Chairman of the White House Council of Economic Advisers under President Clinton, "Don't Throw Out Options Because Investors Took A Bath," Business Week, April 29, 2002."...the problem with treating [stock options] as an expense is that nobody knows how to value it. And...anything that you charge earnings [against] when you issue an option will distort earnings." -Walter Wriston, former Chairman and CEO of Citicorp, Louis Rukeyser's Wall Street, September 13, 2002.
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"Based on the trading of listed options, we know a great number of options tend to be overpriced or underpriced -- yielding opportunities that traders and arbitrageurs look to exploit...What this means is companies could end up overstating or understating their earnings." -Michael Schwartz, CIBC Oppenheimer's chief option strategist, "The Striking Price," Barron's, August 19, 2002. "These models are great for pricing shorter-term options, like listed options that are actively traded, and may not be as suitable for longer-term, more dormant options like employee stock options." -Robert Willens, Lehman Brothers managing director and accounting expert, "The Striking Price," Barron's, August 19, 2002. "Some experts argue that Coke's move could set a bad precedent because expensing stock options makes an income statement more difficult to decipher. `It's a bad idea,' said Robert Blicker, professor of accounting at the Weatherhead School of Management at Case Western Reserve University in Cleveland. `It increases reporting complexity and decreases transparency,' he said. Because stock options are an `opportunity cost' rather than a traditional expense, Mr. Blicker argued, including them as an expense `opens up a Pandora's box' to other noncash items. Among the questions is how changes in the value of options affect profits." -Robert Blicker, Professor of Accounting, Weatherhead School of Management, Case Western University, "Following Lead Of Coca-Cola On Options Would Be Painful," The Wall Street Journal, July 16, 2002. "Option valuation models are designed to provide theoretical values for traded options and are not designed to compensate for the significant limits and restrictions inherent in employee share options...We understand the difficulty in quantifying the appropriate reductions in value for employee share options and, in fact, we are unaware of a way to reliably measure the effect of these differences." -Ernst & Young, Letter to Sir David Tweedie, commenting on IASC/G4+1 Discussion Paper on Accounting for Share-Based Payments, January 21, 2002.
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"...even if the options should, in theory, be expensed, no reliable method has been found to measure that value in a way that would not be misleading to investors." -James A. Klein, President, American Benefits Council, in Letter to Sir David Tweedie, commenting on IASC/G4+1 Discussion Paper on Accounting for Share-Based Payments, December 14, 2001. |
