The Imperfect Science of Valuing Options

There's no one way to figure how they affect earnings

In the face of heavy investor and political pressure, scores of companies will soon disclose what stock options mean for their bottom lines. Expensing options--treating them just like cash compensation--is supposed to shine a light on their true cost. But, in reality, it may leave hapless investors blinded by a fog of incomprehensible calculations.

That's because the way companies value options is an inexact science at best. Current accounting rules give them great flexibility in valuing such compensation, and that's not expected to change when the Financial Accounting Standards Board writes new rules later this year. But just how a business chooses to crunch the numbers could have a huge impact on how options affect reported profits. Indeed, a company expensing options on a $100 stock could reasonably report a hit ranging from as little as $18.68 per option to as much as $59.35.

As a result, it will be nearly impossible for investors to know if a company is lowballing, or to compare options costs among different companies. People "are going to get irrelevant information that they'll use incorrectly," says David Hilal, a managing director at investment banking firm Friedman, Billings, Ramsey. "[Companies] will come up with numbers that will be completely wrong."

To understand the problem, let's walk through a few basics. Companies that choose to expense options will do so at the time they are granted. But those options won't be exercised for years. So businesses have to figure out how much to reduce earnings today to reflect the cost of something that won't be an actual expense until some future date.

Options usually can't be exercised by employees for at least three to five years and generally expire after 10 years. During that time, the company's stock will rise or fall--or both. It may pay a dividend. Some managers may quit before they cash in their options. Others may exercise as soon as they are eligible, while others may hold on. Mark Rubenstein, a finance professor at the University of California at Berkeley, says that some models used to value options require as many as 16 separate assumptions.

Rubenstein found that by adjusting just a few key variables such as stock price volatility or interest rates, he could produce huge differences in costs and, therefore, in the amount a company would have to trim earnings. In one test, Rubenstein found the value of an option for a theoretical $100 stock ranged from $18.68 to $36.32.

Today, most businesses use a mathematical model called the Black-Scholes method to value options. But Black-Scholes was designed to price exchange-traded options, not employee stock options, for which there is no market. Some companies try to improve Black-Scholes by adjusting their estimates to account for such factors as how long execs hang on to options.

Another way to calculate option expense is called the binomial tree model. This uses a different mathematical formula and requires more assumptions. Those who champion the binomial model say it's more sensitive to the variables and arguably more accurate.

As it turns out, there can be a huge difference in value if a company uses this method rather than Black-Scholes. Analysis Group/Economics, a New York consulting firm, has developed one binomial model. It figures that, using its method, a company granting options today on a $100 stock would expense that comp at as little as $34.70. Using Black-Scholes and the same common assumptions, a company might have to take an earnings hit of as much as $59.35.

True, reporting some options cost is better than ignoring the expense. But investors need to be aware that when these numbers start showing up in financial statements, they will be little more than an educated--and perhaps self-serving--guess.

By Howard Gleckman

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