How to value employee stock options (ESO)? This is possibly the central issue in the debate on whether these options should be expensed. According to basic accounting rules, if a value can be placed on this form of compensation, it should be expensed.

Proponents of expensing employee stock options say there are many models that can be used to place a value on options. Opponents argue these models are not applicable to employee stock options. 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 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.

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

1. 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 risk-free rate, stock volatility, dividends (if any) and life of the option. These are hard things to estimate because of the many underlying variables involved. 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.
2. 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 stocks 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.

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 can 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.

Conclusion - 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.

by Rick Wayman, (Contact Author | Biography)