Determining the Future Value Of Stock
Options
By David Fox Employers are increasingly taking advantage
of the motivational power of granting stock options as a form of compensation to key
executives and employees. A stock option gives the employee the right to buy a specific
number of shares within a certain period of time at a fixed price. If the employee chooses
not to buy the shares, the option can expire unused.
Employers may grant two types of stock
options: nonqualified options and incentive stock options (ISOs). Nonqualified options are
not included in income unless the value is readily ascertainable. This usually means that
the stock has to be traded on the open market.
ISOs are more complicated tax-wise and
are rarer since an employer can take no tax deduction for them. While an employee may
exercise an ISO without recognizing any taxable income, certain circumstances still create
a tax. All income is recognized when the stock is sold.
Finding the value of stock options can be
complex. The forensic accountant must usually determine the fair market value of the stock
as well as the tax implications of receiving options, exercising them and selling the
underlying stock.
Some Valuation Factors
To Consider
Although forensic accountants
have set up mathematical formulas to measure different aspects of stock option value, the
process can still be somewhat subjective. Let’s look at an option’s time value.
In theory, the forensic accountant could calculate the present value of the difference
between the option’s value at its expiration date and its exercise price. But the
value at expiration would be an estimate, and the discount rate used would be up to the
forensic accountant. Thus, different forensic accountants would likely derive different
values for these options.
Academia Meets
the Stock Market
Myron Scholes and Robert Merton
won the Nobel Prize for Economics for developing and expanding a ground-breaking method
for pricing stock options: the Black-Scholes option-pricing formula. The formula,
initially conceived by Fischer Black and Myron Scholes, was first developed and published
in 1973. Robert Merton later demonstrated the broad applicability of the model and
extended its theoretical framework to encompass analysis of related financial instruments.
Considered a pioneering formula for the pricing of stock, the Black-Scholes option-pricing
formula led to a tremendous expansion of options markets.
The method was developed at a time when
most investors and analysts were relying on guesswork to price options. The problem was
how to evaluate the risk associated with options when the underlying stock price changes
constantly. Black and Scholes realized that the risk was reflected in the stock price
itself. They then created a formula that includes the stock price, the agreed sale or
"strike" price of the option, the stock’s volatility, the risk-free
interest rate offered with a secure bond, and the time until the option’s expiration.
According to the formula, the value of the call option is given by the difference between
the expected share value and the expected cost if the option is exercised at maturity.
Thus, the Black-Scholes option-pricing model is considered a classic example of an
academic innovation that has been adopted widely in practice.
Introducing
Some Precision
Despite the unreliability of
certain aspects of these calculations, forensic accountants try to introduce some
precision and standardization by considering the following factors:
The volatility of the option’s
underlying stock. Any stock’s volatility can be predicted to an extent by the
degree of volatility it has shown in the past. Wide fluctuations should increase the
option’s time value, because they can raise its monetary worth but not drive it below
zero.
The liquidity of the option and the
underlying stock. Liquidity is important to investors. If the option is for the stock
of a closely held company, it will be discounted for lack of marketability.
The time left until the option
expires. The time left until the option expires makes a difference, because a longer
time gives the stock a greater chance to appreciate. Thus, a stock option with longer to
go until expiration is worth more.
Any dividends the company pays on
the stock. Dividends paid on the underlying stock decrease the option’s value.
Why? The employee doesn’t receive any dividends until he or she exercises the option,
and the earnings paid out aren’t available to fund further growth, which would
enhance the stock price.
The leverage the employee gets from
owning the stock option. Leverage comes into play because the employee either gets an
option as a gift or buys it for less than the market value per share of common stock. As a
result, any appreciation is greater for the option than for the stock itself.
Timing. Proper timing is vital
in exercising options. Generally, postponing the exercise makes sense because the
necessary outflow of cash is deferred. Option holder’s benefit from the appreciation
of the stock without the requisite cash outlay normally associated with a stock
investment. Also, delaying the exercise of these options defers the requirement to pay
income tax at ordinary income tax rates on the exercise of nonqualified options.
Sometimes, though, stock option holders discover that they don’t have enough
financial liquidity to exercise the options. Thus, their options may expire before they
can take action.
Whether exercising the option will
dilute the value of the company’s body of stock. A high number of options in
relation to the amount of common stock drives down the options value. This is because when
the options are exercised they will dilute the common stock price.
Interest rates in the general
economy. Rising interest rates usually increase the value of options. High interest
rates tend to push up the return rates, and push down the values, on the stocks’
underlying options. With values down, opportunities for appreciation increase, especially
since the employee can benefit from the leverage of owning an option rather than the
actual shares.
Various factors
Alter The Value of options
As the use of this powerful
employee incentive becomes more common, you may become involved in a situation that
requires the determination of a stock option’s value. I would be pleased to provide
you with professional assistance in this or any other valuation matter. |
