Human Capital & Careers

FASB Hears New Options Approach

Three finance executives propose a valuation method that uses Black-Scholes and adjusts for S&P 500 volatility.
Craig SchneiderSeptember 16, 2004

Senior finance executives at three technology companies on Wednesday presented the Financial Accounting Standards Board (FASB) with a proposal for a new employee stock-option-valuation model.

The model, to be sure, uses the familiar Black-Scholes method. But the finance executives’ plan proposes, among other things, to benchmark share-price volatility against the volatility of the S&P 500 Index.

As a way of correcting over-estimations of options costs they contend are common under Black-Scholes, Cisco Systems CFO Dennis Powell, Genentech CFO Louis Lavigne, Jr., and Qualcomm treasurer Richard Grannis proposed the so-called “fair value index-adjusted model.”

The proposal comes at an odd time. Earlier this month, FASB tentatively decided not to name a preferred option-pricing model. The board originally said that it preferred lattice-based frameworks, like the binomial model, over Black-Scholes.

The lattice method uses a flexible framework that divides the time from an option’s grant date to its expiration date into small increments, which enables users to make adjustments reflecting expected volatility of share price and other factors over time. The model takes into account many more assumptions about a grant’s features than the more rigid Black-Scholes formula.

Black-Scholes has long been criticized on the grounds that it tends to produce excessive estimates of the value of employee stock options. For its part, critics have said the binomial model is too complicated and too costly for small companies and too ripe for manipulation. The executives’ goal “was to look at and research other sources and develop methodologies that would reduce the cost of reported options,” and better depict the fair value of employee stock options, explains G. Michael Crooch, a FASB board member.

Under the executives’ plan, a company would calculate the volatility of their own stock price as measured against S&P 500 volatility over a period of one, two, or three years, depending on which period provided the best gauge of future volatility. In that way, historically large short-term swings, such as that which occurred during the burst of the stock-market bubble, would not necessarily lead to huge increases of estimated future volatility for companies. Keeping the volatility estimate low also keeps the cost of the options down.

The index-adjusted method, aside from incorporating the S&P 500 index volatility, also adjusts the final Black-Scholes value downward for the unique attributes of employee stock options. That includes adjustments to account for their non-transferability, termination risk, inability to be hedged, dilutive impact on outstanding shares, and blackout period restrictions.

For example, the index-adjusted model would reduce the value recorded by the Black-Scholes model by 50 percent to account for non-transferability.

What’s more, the model proposes using the full contractual term of the option to predict future employee options-exercise behavior. That would eliminate FASB’s proposed requirement that companies estimate the expected term based on past employee exercise behavior.

FASB has a different take on accounting for the special features of employee stock options. Crooch notes that such attributes as blackout periods “are implicitly included” in fair-value model that FASB has proposed.

The finance executives’ proposal, however, argues that if such details were buried, that would leave shareholders at a disadvantage. That’s because they would not be able to know what numbers the company used to value its employee stock options, and therefore won’t be able to reproduce the results, they argued.

Crooch acknowledged that the executives’ proposal has some new approaches for estimating fair value using Black-Scholes that FASB would consider in time. “We have committed to have the staff evaluate this,” he says of the index-adjusted proposal. “We will deliberate it.”