Cheaper Stock Options

Companies are tinkering with the formulas they use to value them

No surprise here: As U.S. companies faced the prospect of having to deduct stock options expenses from their profits starting in 2005, they scrambled to cut their costs. All told, the value of options granted by businesses in the Standard & Poor's 500-stock index has tumbled, from $104 billion in 2000 to $30 billion in 2005, according to a new report by Credit Suisse Group (CSR) analyst David Zion.

Much of the drop has been straightforward: Companies have issued fewer options. But plenty have tinkered with the formulas they use to value them. That's possible because the expense recorded for an option is only an estimate based on assumptions about how long the option will be held, how volatile the stock is, and other factors. Come up with more favorable assumptions and the cost of the option declines.

Volatility estimates are the easiest to rework. Options for volatile stocks carry higher expenses, because the added gyrations mean the holder has a better chance of cashing them in for more money. All together, 382 companies in the S&P 500 cut their volatility numbers in 2005, slashing an estimated $4 billion off the aggregate cost of options.


  Semiconductor maker Intel (INTC) will pocket the biggest gain from the switch. Zion figures that by cutting volatility estimates from 50% to 26%, Intel reduced the price of each option it granted in 2005 by 40%. Apply those savings over the 119 million options it gave out, and he estimates Intel will save $519 million over the options' vesting period. The key question, says Zion, is whether the lower estimates are more accurate or simply more aggressive.

No doubt, some of both. Stocks in recent years have been less volatile than they were during the boom, so a lower number can make sense. And with the advent of expensing, Intel and others have switched from using historical numbers to using "implied" estimates of future volatility based on the price their options fetch in the markets. Because of the 2003-2006 drop in volatility, the implied numbers have been lower than the historical ones. Intel and others say the implied figures are a better indicator of the volatility they're likely to see ahead.


  But are they? Volatilities are heading up. After bottoming at near 10% in December, the Chicago Board Options Exchange's Volatility Index jumped to the low-20% range in June. Analysts think higher volatility will be here for a while. "We've been near 10-year lows," says analyst Chris Senyek at Bear, Stearns & Co. (BSC). "Companies may have made the switch at the worst possible time."

That, of course, depends on your perspective. At companies where volatility numbers have been notched down too far, the cost of options doled out in 2005 has effectively been lowballed.

An honest mistake, perhaps. It's still early in the options-expensing era. But if volatility continues to rise, warns Zion, that fact will have to be reflected in next year's estimates, driving up options costs and weighing on earnings in the future.