Pinning Down the Value of a Stock Option

As Congress and Corporate America ponder the pros and cons of expensing stock options, a difficult issue looms: Even if a company decides that expensing options is the right thing to do, as Coca-Cola Co. (KO ) and Bank One Corp. (ONE ) have recently done, determining just how to value them is tough. After all, an option represents the right to buy shares for an unknown price at some indeterminate point in the future. So how much is that worth? This is the minefield that many companies--and their shareholders--could soon face:

Why is valuing options so tough?

The big problem is that corporations can't predict what will happen to share prices, who will leave the company before their options vest, and which options will expire underwater--that is, with no value. So they have no way of knowing what options will be worth when they're exercised many years after issue. Unlike shares, which have a market value at all times, the true value of options is only known when they're cashed in, in some cases long after the employees who received them provided their service to the company.

Still, most companies prefer to estimate the value of options on the day they're granted--an imprecise method that CFOs have nonetheless become wedded to over the years for its ease of use and predictability. They've developed a number of methods for predicting that future value, none ideal. The choices are mind-numbingly complex and involve making big assumptions that can significantly impact future earnings.

What about the "Black-Scholes" method?

The well-known option-pricing formula, developed in 1973 at the University of Chicago by Fischer Black and Myron S. Scholes, uses option terms such as the strike price and life-span of the option, stock price, volatility, and dividend yield to estimate future value. Black-Scholes and its many variants have, over the years, become the most widely used methods of valuing employee options for disclosure in financial footnotes.

But they are far from perfect. Designed for valuing options traded in open stock exchanges, the standard Black-Scholes formula isn't adjusted to account for the added restrictions of employee options, such as vesting and lack of transferability. Those limits make employee options worth considerably less than exchange-traded options. So, in effect, companies that use the formula to expense options would take a much bigger charge to earnings than is necessary. Bear, Stearns & Co. estimates that using the Black-Scholes model to expense options would have trimmed 20% off the earnings per share of the Standard & Poor's 500-stock index last year; 13 companies, including Microsoft Corp. (MSFT ) and Cisco Systems Inc. (CSCO ), would each have had to deduct pretax options expenses in excess of $1 billion in 2001 alone.

What does Coke plan to do?

Each October, Coke says, it will ask two Wall Street firms to provide binding quotes on options to buy 10,000 shares of Coke stock and options to sell 10,000 shares. The average of the four quotes would be used to determine the options' value, and thus the charge to earnings.

By using an "objective third party," Coke hopes to avoid any accusations that it tweaked the numbers. Coke says the firms may choose to use Black-Scholes to value the options, but it will be up to them to determine each of the variables, making it impossible for Coke to game the process. The binding quotes, meanwhile, provide a guarantee that the firms won't lowball the valuations in an effort to reduce Coke's charge to earnings--and possibly secure future business. If the firms gave Coke a ridiculously low price, Coke could simply buy the 10,000 options from them and book a one-time gain to profits.

Why not just wait until the options are exercised?

By waiting until employees exercise their options, then booking the difference between the exercise price and the stock price as an expense, companies would record the precise cost of the options. That sum would equal the amount the company would spend to buy those shares on the open market, or the amount the company is forgoing by not selling the shares and pocketing the funds itself. And options that never get exercised never get expensed. This is the only way of accurately stating the true cost of options to the company.

Unfortunately, simply waiting also violates most of the accounting principles about expense recognition that auditors hold dear. Companies are required to deduct expenses during the period in which they are incurred--that's why equipment is amortized over its useful life instead of being expensed when it's purchased or sold. Expensing options only when they are exercised violates that basic principal, sometimes requiring companies to deduct the option expense long after the employee's period of service. An executive who retires with a boatload of vested options would, in this scenario, create a huge expense when he exercises them--one that should properly have been taken throughout the period when he was employed.

Are there any other methods that avoid these problems?

To achieve much the same result of expensing at the time of exercising, some recommend a method known as intrinsic value. A company expenses the difference between the exercise price and the stock price throughout the vesting life of the option, repeatedly updating it as the stock moves. As the stock price rises, options become more valuable, and that additional value is charged to earnings. If the stock declines, options decrease in value, and the charge to earnings evaporates.

Companies that employ this method get a whole host of benefits. Unlike Black-Scholes, the simplicity of intrinsic value makes it tough to manipulate. Moreover, since the charge to earnings is considerably lower than any of the Black-Scholes variants, it's less disruptive to earnings--and the stock price. In a declining market, it's also the only accounting method that doesn't create a charge for underwater options.

Intrinsic value also has another possible appeal for investors: It may discourage massive option grants to underperforming executives, who frequently get rewarded for failure with grants designed to match the Black-Scholes value of last year's grant. No Black-Scholes, no need for bigger options grants every year. There is, however, one major disadvantage: For volatile stocks, the earnings charge is hard to predict, which is why this method is not widely used.

So what's the best?

Intrinsic value isn't perfect, but it's far less imperfect than the alternatives. It may be the best hope yet for solving the options dilemma.

By Louis Lavelle in New York

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