Copyright 2002 Chicago Sun-Times, Inc. Chicago
Sun-Times
August 8, 2002 Thursday
SECTION: FINANCIAL
LENGTH: 516
words
HEADLINE: No easy way to value stock
options
BYLINE: Sandra Guy
BODY: As more companies choose to treat stock
options as expenses, one question keeps popping up: What is the best way to
value stock options?
The Financial Accounting Standards
Board, the panel that sets U.S. accounting standards, prefers that companies
determine the "fair" value of the options they grant executives and
employees.
Q. What is an option anyway?
A. A stock option is a contract that permits the owner--a
CEO, an employee, etc.--to buy stock at a fixed price before a specific date. A
common stock option contract would involve giving a CEO the right to buy 10,000
shares of company stock at $10 a share before Dec. 31, 2005. If the stock
sells at $30 a share before Dec. 31, the CEO invokes the option contract,
and sells the stock at the market price.
Typically, a company uses shares that it has in its treasury to make
good on its option contract.
The difference
between the $10 option price and the $30 market price is
considered a business expense, and is therefore deductible on the company's
income tax.
Q. Why is the process of valuing
options so difficult?
A. Companies have no
way of knowing what options will be worth when an employee cashes them
in.
Options usually are cashed in years after
they are issued. So most companies are choosing to estimate the value of options
on the day they are granted.
But the methods
used to make these estimates differ widely. The mathematical models require
companies to make assumptions about a variety of factors, including their
stocks' future volatility. Even small changes in the assumptions can have big
impacts on a company's reported earnings.
Q.
What are the methods used to expense options?
A. The most widely used method is called the Black-Scholes options
pricing model, named after the two University of Chicago professors who came up
with it in 1973.
The formula's biggest drawback
is that it is designed to value options traded in open stock exchanges.
Therefore, it isn't adjusted to account for the
peculiarities of employee options, which have vesting periods and which cannot
be sold.
Q. What is the alternative to
Black-Scholes?
A. Coca-Cola Co. has decided
to go its own way. Each October, it will ask two investment banks to offer
binding quotes on options to buy 10,000 shares of Coke stock and options to sell
10,000 shares.
Coca-Cola will average the four
quotes to come up with the options' value and the expense to earnings.
Q. What are other complexities?
A. The accounting standards used by companies in the
United States differ from those used by companies overseas.
Since the London-based International Accounting Standards Board is
expected to require companies to expense stock options, the U.S. accounting
agency is expected to follow suit, perhaps as early as this year.
The IASB and the FASB will have to reconcile their
rules, including whether to update options' value when employees leave and
whether to estimate how many employees will leave a company before they are
eligible to exercise their options.
Document 9 of 19. 