How do you value employee stock options (ESO)? This is possibly the central issue in the debate about whether these options should be expensed or whether this method of compensation can be left out all together from the income statement but noted in the notes of the financial statements. According to basic GAAP accounting rules, if a value can be placed on employee stock options, they should be expensed at the fair market value.

Tutorial: Employee Stock Options

Proponents of expensing employee stock options say there are many models that can be used to accurately place a value on options. These options are a form of compensation that should be properly accounted for, like wages. Opponents argue these models are not applicable to employee stock options or that the corresponding expenses associated with this form of compensation are zero. This article will take a look at the argument of the opponents and then explore the possibility of a different approach to determining the cost of employee stock options.

The Arguments Against
Several models have been developed to value options that are traded on the exchanges, such as puts and calls, the latter of which is granted to employees. The models use assumptions and market data to estimate the value of the option at any point in time. Perhaps the most widely known is the Black-Scholes Model, which is the one most companies use when they discuss employee options in the footnotes to their SEC filings. Although other models such as binomial valuation were once permitted, current accounting rules require the aforementioned model. (Learn more in Get The Most Out Of Employee Stock Options.)

There are two main drawbacks to using these types of valuation models:

  • Assumptions - Like any model, the output (or value) is only as good as the data/assumptions that are used. If the assumptions are faulty, you will get faulty valuations regardless of how good the model is. The key assumptions in valuing employee stock options are the stable risk-free rate, stock volatility follows a normal distribution, consistent dividends (if any) and set life of the option. These are hard things to estimate because of the many underlying variables involved, especially regarding the assumption of normal return distributions. More importantly, they can be manipulated: by adjusting any one or a combination of these assumptions, management can lower the value of the stock options and thus minimize the options' adverse impact on earnings.
  • Applicability - Another argument against using an option-pricing model for employee stock options is that the models were not created to value these types of options. The Black-Scholes model was created for valuing exchange-traded options on financial instruments (such as stocks and bonds) and commodities. The data used in these options are based on the expected future price of the underlying asset (a stock or commodity) that is to be set in the marketplace by buyers and sellers. Employee stock options, however, cannot be traded on any exchange, and option-pricing models were created because the ability to trade an option is valuable.

An Alternative Viewpoint
Outside of these theoretical debates, there is a real hard-dollar cost to employee stock options and it is already disclosed in the financial statements. The real cost of employee options is the stock buyback program, used to manage dilution. When stock options are exercised, they dilute shareholders' wealth; in order to counter these effects, management should repurchase shares. (Learn more in Expensing Employee Stock Options: Is There A Better Way?)

Companies use stock buyback programs to reduce and therefore manage the number of shares outstanding: a reduction in shares outstanding increases earnings per share. Generally, companies say they implement buybacks when they feel their stock is undervalued.

Most companies that have large employee stock option programs have stock buyback programs so that, as employees exercise their options, the number of shares outstanding remains relatively constant, or undiluted. If you assume that the main reason for a buyback program is to avoid earnings dilution, the cost of the buyback is a cost of having an employee stock option program, which must be expensed on the income statement.

If a company does not have a stock buyback program, then earnings will be reduced by both the cost of the options issued and dilution. Even if we take buybacks out of the equation, options are a form of compensation that has a certain value. As a result they must be addressed in a similar fashion to regular salaries.

The Bottom Line
Stock options are used in lieu of cash wages, period. As such, they should be expensed in the period they are awarded. The cost of a stock repurchase program can be used as a way to value those options because in most cases management uses a repurchase program to prevent EPS from declining.

Even if a company does not have a share repurchase program, you can use the average annual share price times the number of shares underlying the options (net of shares expected to be un-exercised or expired) to derive an annual cost.

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