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Strategies & Market Trends : Employee Stock Options - NQSOs & ISOs -- Ignore unavailable to you. Want to Upgrade?

To: rkral who wrote (74)	6/18/2002 2:24:05 AM
From: Stock Farmer	Read Replies (2) \| Respond to of 786

JS: Is it the conditional promise itself that has value? Or the value that follows later that has value? RK: Both You assert this, but you can not prove it. If you could, you would be able to show that an option has value OV given by the sum of the value of the promise (PV) plus the expected value of exercise in the future (EV). Specificly that OV = PV + EV. See below what happens when I take this as a premise. >>"So you see that it is fair to claim that there is not any actual economic value transferred on grant. HOWEVER, this doesn't stop us from declaring the option to "have value" and to assign a fair price!!!"<< I don't see that at all. Obviously. You seem to think that somebody gained actual economic value, as opposed to having gained an expectation of future economic value that hasn't actually been gained yet. This very fine distinction has eluded you through numerous posts. And yet for some reason I am patiently persistent. Even an option that expired worthless had an actual non-zero value on grant. Yes. The value it had was the expected future value it had back then. This does not prove that it had a different value than its expected future value. It does demonstrate an example of actual values ending up different from expected values. John, you've made that presentation many times .. and, as best I can recall, always without any proof .. or even a shred of corroborating opinion. Why do you think such a presentation should be convincing to anyone? Actually Ron, in the first place, I have already referred you to the seminal paper on option valuation, which you apparently have not read. Or which you did not comprehend. I am articulating the reasoning in words. SI provides only a forum for dialogue. In the second place, you seem to need a lot more "proof" than most other people in order to accept something. I can not easily prove that the sun will rise tomorrow, yet if I assert so would you demand that I prove it? Provide corroborating evidence? FASB SFAS 123 is not a treatise on how to value options. It merely suggests how accountants should account for such things. Recall that other accounting rules also allow companies to account for the same thing as having value zero. And the IRS suggests that companies account for them in yet another way. So here we have three authoritative sources suggesting three ways to account for the value of stock options. It is not impossible that all of these interpretations are simultaneously CORRECT!!! And that there are other ways too!!! You may recall from the dim dark recess of your mathematics education that depending on how you section a cone you get a hyperbola, parabola, ellipse or circle. The same thing can give rise to many different interpretations without inconsistency. The important thing is to stand back and recognize the parameters giving rise to each. When you figure this out for stock options you will have come a long way. In the third place, it seems to me quite self evident on its face that an option is worth only what someone expects to get from it. After reducing everything to present value, would you pay more for an option than you expect to be able to get on exercise? I assumed you were smarter than that. Would you sell one for less? Surely you aren't so daft. Not for more, not for less, that leaves equal. Doesn't it? Or do you think that there is some other way of valuing options that should apply to everyone else and not you? But you want proof??? OK. Try this for proof. Let's start by assuming you are correct. That is to say, that the fair value of an option is DIFFERENT than the expected future value on exercise. We use the classical definition of "fair value". Namely as the price at which a fully informed buyer and a fully informed seller, operating from the same assumptions, would both rationally conduct the exchange of cash for option. As opposed to "unfair" value where one party profits at the expense of the other or where both parties operate on the basis of different assumptions. Let us define EV as the expected future value of an option on exercise. To be exact, this is the expected difference between strike price and market price, over some period of time in the future discounted back to present value. I called this "the value that follows later". Let us define OV as the current value of an option. And let us define PV as the difference between the two, alternately as the value of the conditional promise itself. Mathematically, by asserting that both are present in the value of an option, that means you claim OV = EV + PV. By hypothesis, our buyer and our seller have identical basis for expecting the future value of the option, EV and PV and thus OV. But now let us look at the perspective of each. First the buyer. He will pay OV at purchase for something he expects to get EV on exercise thus ends up expecting a return of EV-OV = EV-(EV+PV) = -PV. In other words, a rational purchaser expects to lose PV on purchase of an option. Such a purchase is a rational decision only for those values of PV which are equal to or less than zero. Giving rise to Condition (1) as a prerequisite for a purchase of this option at price OV: PV <= 0 Someone holding an option can expect to hold the option for future exercise and receive an expected value EV, or sell it and receive OV. In the event of a sale they then expect to get OV and give up EV to net out with a gain of OV-EV = (EV+PV)-EV = PV. This is a rational decision only for those values of PV which are equal to or greater than zero. Giving rise to condition (2) as a prerequisite to sale at OV: PV >= 0. The only value of PV which simultaneously satisfies these two conditions is PV=0. Or OV = EV + 0 Or OV = EV QED The fair value of an option is what we can expect it to be worth on exercise in the future. Period. Not a penny more, not a penny less. And you won't find this in FASB SFAS 123. John

To: rkral who wrote (74)	6/18/2002 10:52:40 AM
From: Gary L. Kepler	Read Replies (2) \| Respond to of 786

Perhaps the following poster can be drawn into a discussion. Check out his profile using the link below: "once they implement proper expense accounting of options" As it happens, I think I have more practical experience with expense accounting of options under FAS 123 than anyone else in the US. Based on that experience, I'd say it's generally about as realistic as Enron accounting. You have to estimate factors like future volatility and option life that there is no sensible way to estimate. For some imploding telecom companies in 2002, there was actually a net credit from option expenses because of the impact of all their employee terminations and consequent option forfeitures causing a reversal of prior-year expenses. Is that really a number you want folded into reported earnings? Message 17616774