Windows into Valuation

Microsoft Corp.'s July announcement that it would stop issuing employee stock options — and expense all existing equity compensation, including stock grants — represents a huge break from the rest of the technology industry. But if anything, the software giant is now even more embroiled in the contentious debate over whether — and how — to expense stock options.

Microsoft plans to allow employees to sell existing underwater options to JP Morgan, but so far the investment bank has offered just a fraction of the price Black-Scholes puts on them. Opponents of expensing say the bank's low bids prove that existing pricing models overvalue options. "When JP Morgan is willing to pay 25 cents and Black-Scholes says $7.97, it illustrates that current valuation methods don't work," says Kim Boylan, counsel to the International Employee Stock Options Coalition.

Current option-accounting rules allow companies to use either market price or models like Black-Scholes. However, historically, market prices haven't been available, because stock options have not been transferable. But some observers think Microsoft's move may presage the development of a real market. A record of those transaction prices "could be a key step in getting markets for options going," insists John Finnerty, a finance professor at the Fordham University Graduate School of Business, "and in helping value employee stock options for financial-reporting purposes."

This is all still speculation, but an actual market for trading employee stock options is a prospect that has long tantalized investment banks. Before Microsoft's move, Finnerty and others figured that creating a market would require complex derivatives contracts that could mirror the underlying options.

"Microsoft is doing what it does well, which is acting as a bellwether," says Eric Reiner, a managing director at UBS AG. Yet historically, finance has not been the company's strong suit — a fact it tacitly admitted in July when it placed CFOs at the head of each of its seven reorganized business units. Thus, if the software giant ultimately helps solve an issue that has challenged the brightest minds on Wall Street, it will be almost as ironic as the fact that it gave up stock options in the first place.—Tim Reason

Ticker Tales

When word leaked out in late July that the Pentagon was working on a plan to create a futures market on the likelihood of such events as a terrorist attack, criticism was so harsh the plan was scrapped the next day.

The idea was that trading in futures based on political events could help predict and thus prevent them. And while terrorism futures might be a terrible idea, Hal Varian, a business professor at the University of California-Berkeley, insists the underlying concept is not as nutty as it sounds. "Markets do an awfully good job of forecasting many events and trends," he says.

Markets can aggregate many small pieces of information into a bigger picture. For example, orange-juice futures accurately predict cold weather in Florida, says Varian. And the Iowa Electronic Markets have been predicting political elections with great success for 15 years. "Changes in supply and demand move information quickly and efficiently," adds Robert Forsythe, co-founder of the market at the University of Iowa.

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