A new option expensing proposal from Cisco, Qualcomm, & Genentech
An excerpt from an article by Graef Crystal
bloomberg.com
>>"This latest proposal seems to be all sweet reason. It accepts the Black-Scholes model as the standard for determining charges to earnings. It backs away from an earlier tech proposal to assume that stocks have zero volatility. And it recommends using the entire term of the option in calculating present value, not some foreshortened term that is currently allowed under FASB rules to approximate the average time between option grant and option exercise.
What's the Gimmick?
Yet as I read it, I kept asking myself: ``What's the gimmick?'' Turns out that there's not just one gimmick, there are many.
First, the volatility assumption to be used is the volatility on the Standard & Poor's 500 Index multiplied by the particular stock's adjusted Beta. Sounds reasonable, since higher-risk stocks are assigned higher volatilities and hence would be required to take higher charges to earnings.
But based on my analysis of daily S&P Index closing prices since Dec. 31, 1973, the most likely starting point for volatility -- that is, before factoring in the Beta adjustment -- is a volatility of about 16 percent.
Looking at the distribution of historic implied call volatilities of the stocks composing the index, a volatility of 16 percent approximates the first percentile of the distribution, meaning that 99 percent of the S&P 500 companies have the same or a higher volatility. Using an assumption this low guarantees that your typical company will get lesser charges to earnings for option grants.
Lowering the Net
So, for openers, the three companies have lowered the tennis net to about six inches off the ground. That makes for a much easier game.
Then they propose a series of four different discounts to their already-low Black-Scholes values. That not only puts the net on the ground, it digs a trench and buries it. Each discount is applied separately to the original Black-Scholes figure.
-- A discount of up to 50 percent for lack of transferability and termination risk.
-- A discount for inability to hedge the transaction. In an illustration accompanying the proposal, that discount would run to 25 percent or so.
-- A discount for the fact that options may not be exercised in so-called ``blackout periods.'' The likely range here would be 5 percent to 10 percent.
-- A discount for dilution that is a function of how many options are granted. That's a real doozy, because if you follow the math, the more options you grant, the lower will be the charge to earnings for each one of them.
Put together, all those discounts have the potential for reducing the already-low Black-Scholes value by a further 80 percent or thereabouts.
Producing a Profit
With a little more work, those creative people in California could have produced a discount to the Black-Scholes value that not only doesn't cause earnings to drop, but actually produces a profit."<<
!!!!!
If anyone has a link to the actual proposal, please post.
Thanks, Ron |
