Valuation of Employee Stock Options George Montgomery CFA

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Valuation of Employee Stock Options George Montgomery, CFA, FRM Montgomery Investment Technology, Inc. Radnor,

Valuation of Employee Stock Options George Montgomery, CFA, FRM Montgomery Investment Technology, Inc. Radnor, PA Phone: 610 -688 -8111 www. fintools. com

Accounting for ESOs FASB’s stated goal was to improve disclosure of employee stock options:

Accounting for ESOs FASB’s stated goal was to improve disclosure of employee stock options: “to level the playing field” APB 25 only required the Intrinsic Value calculation FAS 123 “encourages” companies to expense options granted using the Black-Scholes, binomial or other appropriate model www. fintools. com

FAS 123 Compromise ruling after 11 years of evaluation and debate Companies do not

FAS 123 Compromise ruling after 11 years of evaluation and debate Companies do not have to expense option grant value Only a footnote disclosure is required Flexibility in determining inputs to option pricing model allowed: time to expiration and volatility www. fintools. com

Standard Option Valuation Black-Scholes Modified Black-Scholes Binomial Flexible Binomial CEV Volatility benchmark from historical

Standard Option Valuation Black-Scholes Modified Black-Scholes Binomial Flexible Binomial CEV Volatility benchmark from historical prices Interest rate data from Federal Reserve www. fintools. com

Non-Standard Options Barrier (Knock-in, Knock-out) Average Price (dampens volatility) Spread (out-performance, index) Stepped-strike Some

Non-Standard Options Barrier (Knock-in, Knock-out) Average Price (dampens volatility) Spread (out-performance, index) Stepped-strike Some “closed-form” solutions exist Monte Carlo simulation is often used for more complex contracts www. fintools. com

Hedging Exposure Some companies have opted to hedge the exposure that is created when

Hedging Exposure Some companies have opted to hedge the exposure that is created when stock options are granted Some investment banks are willing to take on the risk The cost of hedging might seem high to some companies: does that mean that the compensation is too high? www. fintools. com

Current Issues Transferability Reissue of options after a drop in stock price (company or

Current Issues Transferability Reissue of options after a drop in stock price (company or market related) More targeted incentive objectives Do employee stock options achieve the stated goal? Why does Warren Buffett “substitute a cash compensation plan of equivalent economic value”? (Forbes, May 18, 1998) www. fintools. com

END SLIDESHOW To go back to FAS 123 page: FAS 123 www. fintools. com

END SLIDESHOW To go back to FAS 123 page: FAS 123 www. fintools. com

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