Big Companies Go Black-Scholes Route

But an unexpectedly high percentage of corporations surveyed use the binomial model to value stock options instead, says a new study.
Marie LeoneMay 3, 2006

Early evidence suggests that large companies prefer using the straight-forward options-valuation model known as Black-Scholes, rather than alternative methods. The findings are detailed in a new study released by Compliance Week that examined the annual reports of 50 companies that award stock options to employees and have revenues of more than $20 billion.

The study found that 80 percent of the companies used the fast-track Black-Scholes model instead of the more complicated binomial “lattice” model. Nevertheless, the fact that 20 percent of the companies used the binomial model is “surprising,” Matt Kelly, managing editor of Compliance Week said in a press release. According to Kelly, industry experts predicted that only between 5 percent and 10 percent of the companies valuing options would use the binomial method.

The size of the companies the publication studied may be one reason for the unexpetedly high number of binomial model users. The median revenue of the companies is $37 billion, and larger companies tend to have the internal resources and accounting expertise needed to value options via the more complex model.

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Complicated though it is, the binomial method has proved valuable for such companies, said Kelly. Using the model can help them “generate lower option costs, and these big companies typically have large option expenses that justify the extra effort,” he added.

Five of the 10 companies using the binomial method said they switched from the Black-Scholes model within the past three years. The quintet consists of Caterpillar, Citigroup, Metlife, United Technologies, and Wellpoint. McDonald’s used a closed-form pricing model, but did not specifically say whether it had switched from the Black-Scholes methodology, according to the publication. The remaining four binomial model users are Boeing, Dow Chemical, Prudential Financial, and UnitedHealth.

Study companies using the Black-Scholes model range from General Motors and Chevron—which generate $194 billion and $185 billion in revenues respectively—to 3M and Coca Cola—which generate $21 billion and $23 billion in revenues respectively.