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Could Google's Options Experiment Open Door To Reform Of Accounting Rules?
from the ch-ch-ch-changes dept
The move towards valuing employee stock options using Black-Scholes hasn't had the calamitous effect on the tech industry that some predicted, but there's still a lot of doubt as to whether the method is the best one for meaningfully conveying the cost of options to investors. Last year, Cisco proposed a market-based approach for valuing options, in hopes of arriving at a more accurate number than Black-Scholes. The SEC rejected the idea, but appreciated the spirit of the proposal, and noted that such a system, if constructed properly, might be worthwhile. Today Google announced that it would set up a new program to allow its employees to sell their stock options early to institutional traders. The idea is that for the employees it may help them realize their value earlier, while the traders may wish to buy them for hedging purposes. The plan doesn't specifically revolve around the issue of expensing, but it's easy to see it going down this road. Once trading commences, it will be easy to see whether the prices align with what Black-Scholes would predict. Or, if there's a major divergence, then it might call into question the use of Black-Scholes for this purpose. Another possibility is that Google could report two sets of numbers, one calculating options based on Black-Scholes and the other based on the cost derived from this market. Because neither method has any real bearing on the company's operations, the choice of which numbers to accept could simply be left up to the investing public.
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Why fair price is important
Evostick posted some of this before I finished writing, but here's a little more info.
Suppose you work for XYZ Inc. and get an options grant on 1000 shares at the current price of $50; it's good for 2 years. Each option gives you the right to buy a share at $50. If the price is $100 at expiration you exercise your option at $50, sell the shares at $100, and your profit is 50 * 1000. That's what everybody hopes will happen. If your company tanks and its stock price is $20 after 2 years, you just let the options expire. No loss - just move on.
Currently, these kind of employee options are not tradable -- whatever happens, they're still yours. Along the way, you can always compute the difference between your price and market price to see approximately what your profit will be ($0 on up) and we tend to think about that as the "value" of the option.
Introducing options trading to this situation will highlight another "value" number for the option in the following way: If I think you company will do well and I'm considering buying your options after a year when the stock price is $60 and there's another year remaining, I certainly could pay up to $10/option, since I can get that back right away and break even and you wouldn't sell it for less than $10, since you can get that much back yourself.
In addition, since I think the stock will go up, I'd probably pay a couple of bucks premium over the difference. Why? If the company's history shows growth, the likelihood is the stock will go up over the next year - maybe I think it will hit $70. If I bought the stock, I'd invest 1000 * $60 in the hopes that I'd get back $10,000 profit in a year (16+% return). However, I could lose a lot if I'm wrong -- if it hit $20, I'm out $40,000; bankruptcy means a $60,000 loss. With the option, I'd invest 1000 * $12 (say) in the hopes of the same $10,000 (an 83+% return), but if I'm wrong my loss is limited to the original $12,000. In certain circumstances, that might be a much better investment for me -- not always, since there is much greater volatility in the option price than the stock price and they expire at some point (maybe before they hit my target of $70.)
So how much premium should I pay? What's a fair price for the option when there's so much uncertainty about the future? That's what Black and Scholes tried to determine. In the 70's, there was no standard structure for options and no exchange that made a liquid market in option trading. Brokers used to take out small ads in the Wall Street Journal listing a few options and the set asking price. How would you know if it was reasonable? It was mostly a seat-of-the-pants guesstimate.
The result was the Black-Scholes equation, which took as input 1) the exercise price, 2) the stock price, 3) the time remaining before expiration, 4) the volatility (beta) of the stock and 5) the current no-risk interest rate (US bonds) and produced a "fair" price for the option. (1) - (5) were things you could measure. It was the first tool that had any substance and gave traders at least a reasonable reference point. It isn't a solvable equation -- it resembled the heat transfer differential equation right out of college physics and involved a calculation using the integral for the normal probability distribution. I remember using a TI calculator which had a program to do the math and that became a standard tool for options trading. When a couple of exchanges started trading options, the terms of the options became standardized (important for trading) and Black-Scholes was used extensively to spot "bargains" in the options offerings. Now it's a standard evaluation tool used by all whether or not you like it -- you need to know the B-S "fair" price because that's what most everybody else is using. (There are other methods not as widely used.)
The SEC doesn't care what normal traders use to value options -- it's an open and free market -- pay your money and take your chances. However, they do care about how you keep your corporate books. The difference between not accounting at all for employee stock options and expensing them using the current stock price is significant, and neither extreme seems to adequately describe what's really going on. Simply expensing them probably overstates their impact on the corporate books and investors. So the same question comes up again, "what's a fair price" for a typical employee grant? Obviously, any method you use to value an option needs to be accepted by the SEC and B-S is clear cut and widely accepted.
Market valuation (as proposed by Cisco) will run into at least one difficulty. The big option markets use standardized terms (ie. 3, 6 and 9 months), expire on a predictable schedule, trade in standard increments for exercise price, etc. Employee stock options are rarely so organized and typically are for much longer terms and are owned by a limited set of people. It's likely that market value would be a pretty fuzzy valuation tool.
Using Black-Scholes would provide a more widely accepted and deterministic method to determine a reasonable price.
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