What Is The Future Worth? Determining the Value of Stock Options

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 valuation advisor 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 valuation advisors have set up mathematical formulas to measure different aspects of stock option value, the process can still be somewhat subjective. Letís look at an optionís time value. In theory, the valuation advisor could calculate the present value of the difference between the optionís 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 valuation advisor. Thus, different valuation advisors would be likely to come up with different figures.

The Black-Scholes Option-Pricing Formula: Academia Meets the Stock Market

Myron Scholes and Robert Merton won the 1997 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 stock pricing, 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 included the stock price, the agreed sale or ďstrikeĒ price of the option, the stockís volatility, the risk-free interest rate offered with a secure bond, and the time until the optionís 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.

The 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, valuation advisors try to introduce some precision and standardization by considering the following factors:

The volatility of the optionís underlying stock. Any stockís volatility can be predicted to an extent by the degree of volatility it has shown in the past. Wide fluctuations should increase the optionís 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 optionís value. Why? The employee doesnít receive any dividends until he or she exercises the option, and the earnings paid out arenít 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 holders benefit from the appreciation of the stock without the requisite cash outlay normally associated with a stock investment. Also, waiting 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 donít 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 companyís body of stock. A high number of options in relation to the amount of common stock drive down the optionsí 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 stocksí 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

The factors that can raise or lower the value of a stock option work differently depending on the combinations and circumstances. 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 optionís value. We would be pleased to provide professional assistance in this or any other valuation matter.

June 1998