U.S. companies raising capital abroad already have an incentive to adopt the binomial model; the IASB has effectively endorsed the model in its own rule, already finalized, that requires options to be expensed. In essence, the international standards-setter requires that companies take their cue from what "a knowledgeable willing market participant," such as a derivatives trader, would use to value the option. The rule also notes, "This may preclude the use of the Black-Scholes model."
Some experts worry that investors may be confused if two companies in the same sector use different models, because investors are far less likely than CFOs to evaluate the assumptions involved. "An ordinary investor may or may not know how to do that," says the AIMR's McEnally, "and that's the problem."
And some finance executives remain deeply skeptical that either model works well with employee options. As Donna Blackman, director of accounting policy at Marriott International, puts it: "Whether FASB tells us what to use or says use your own judgment, I think Black-Scholes as well as the binomial method are imperfect."
That said, at present Marriott values options using Black-Scholes for footnote disclosure purposes; the company will wait for guidance from FASB before deciding whether to switch to the binomial method, if option expensing is required. Yet it's unclear just how helpful the board will be. Typically, FASB doesn't recommend one valuation model over another, but Mercer's Eichen believes that FASB's exposure draft may be much more prescriptive than usual and will severely limit companies' ability to use Black-Scholes. The rule-makers, she says, want to avoid letting companies "try both and pick the one that gives them the lowest option cost." For that reason, she expects that "companies may have to demonstrate a good reason for using Black-Scholes."
Eichen says the U.S. rule-maker "may be even more specific or even more limiting in its language." She's heard more than one FASB board member express strong reservations about Black-Scholes, and she's seen little to indicate that FASB has adopted the more general, principles-based approach to rulemaking favored by the IASB.
In other words, CFOs had better start boning up on the binomial.
Valuation Studies at 20 Paces
Predictably enough, consultants disagree over the virtues of the binomial method for valuing employee stock options.
On one side is the Boston-based Analysis Group, whose recent study concluded that the Black-Scholes method can overestimate the value of employee options by anywhere from 28 percent to 56 percent. On the other side is Mercer Consulting. Mercer's study of 350 major companies with broad-based stock-option plans found that in 75 percent of the cases, the two formulas produced a cost differential of less than 5 percent.
Susan Eichen of Mercer goes so far as to say that the Black-Scholes and binomial models "will give you the same results," provided you plug in the same set of assumptions. Mercer assumed that options were granted at the money; that the exercise price was equal to the stock price at the grant date; that the company paid a moderate to low dividend; and that the exercise occurred at the end of the contractual term (an assumption also made by the current accounting rule, FAS 123).
Yet Eichen acknowledges that most employees do not hold on to their options for the full term. "The approach we've taken is simply for comparative purposes," she says, "to get a sense of the full value of the options."
Analysis Group, for its part, concedes that the two models can produce the same result for options that are easily traded. "If you take the Black-Scholes model and compare it straight away against the binomial model designed for valuing exchange-traded options, given the same inputs, those two models will produce similar results," says Ron Rudkin, a vice president of the firm. Rudkin adds, however, that employee option grants are completely different from other options because of their vesting schedules, lack of transferability, and forfeiture requirements, which the Mercer study doesn't take into account.
What's more, contends Rudkin, a dividend payment of any size will produce a greater value for employee options under the binomial model than under Black-Scholes. Yet it may be inappropriate to assume that a company with a broad-based option program pays any dividends, since the typical such company is an entrepreneurial enterprise that must reinvest most if not all of its cash.
Who's right? Hard to say. But the answer may become a bit clearer if, as expected, the FASB throws its weight behind the binomial model. —C.S.
Reader Comments» Post a comment