Valuing Employee Stock Options
A Guide for Choosing Either Lattice or Black Scholes
As I draft this, comfortably ensconced in seat 6F on a flight home from the September meeting of the Appraisal Issues Task Force (AITF) in New York, it is admittedly difficult to believe the furor that erupted last year over the FASB's proposal to expense stock options. Currently, SFAS 123R is headed for the compliance phase, and the topic for discussion at the AITF is now the future of purchase price allocation, or SFAS 141R. Looking out my window at 35,000 feet I can see for hundreds of miles, and from that perspective it is apparent that 141R is but one part of the FASB's herculean effort to drag financial reporting out of the iron age and into the information age. Nevertheless, at 500 miles an hour I'm still not moving as fast as the changes in financial accounting as I know it, and pooling accounting doesn't look so bad.
Right now, finance professionals at companies across America are working late trying to figure out how best to value their equity based compensation to be ready to comply with SFAS 123R. This involves a range of considerations, but chiefly among these is choosing whether to value employee stock options using a closed form approach, such as the Black Scholes Option Pricing Model (Black Scholes), or some kind of lattice model such as a binomial model. In the initial exposure draft, the FASB favored lattice models over Black Scholes, but in the end sanctioned the use of either methodology. So how should a company decide how to value their employee stock options? Mercer Capital has done option analyses for many years and for many different purposes. We tend to think that Black Scholes is generally more user friendly simply because it has only six inputs ("user" can be defined here as company management, auditors, and the investment community). Despite this, lattice models have generated quite a loyal following because they are far more flexible and are, there-fore, thought to offer more precise indications of value. In the end, the models consider similar ranges of behavior in different ways, but typically do not result in materially different conclusions of value. So "getting the right answer" is not the primary criteria in choosing a valuation methodology for compliance with SFAS 123R.