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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  1.  
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    misanthropic humanist, Dec 14th, 2006 @ 12:47am

    Wooooosh

    Sorry Joe, that's the sound of that article going over my head.

    Options like maybe taking the train or the bus to work? I can see that the train is the more expensive option, but how do the deadly accurate passes of the Manchester United midfielder feature in this?

    "Today Google announced that it would set up a new program to allow its employees to sell their stock options early"

    Aha, so like beef or chicken yeah? Google write such great programs I can't see how that could fail.

    "The idea is that for the employees it may help them realize their value earlier"

    Like in their teens or early twenties? I think properly reared children have self esteem to know their value before they even start work.

    "while the traders may wish to buy them for hedging purposes."

    Oh, I feel like such a fool. So this all about gardening?

    Tell us something about technology Joe :)

     

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  2.  
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    Chris Westland, Dec 14th, 2006 @ 1:54am

    Google's Options

    Kudos, Google for daring to question received finance wisdom -- repeatedly. There is nothing magical about lack-Scholes pricing (in fact it wasn't even developed by Black and Scholes, rather by one of their PhD students, who only belatedly received credit). At least one of its underlying assumptions is a bit dodgy -- the existence of a perfectly riskless hedge (i.e., assumes there's something comparable to Google but without any risk). Google is willing to go out there and actually test academic wisdom in the market. They also seem to be right a lot of the time.

     

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  3.  
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    misanthropic humanist, Dec 14th, 2006 @ 2:09am

    riskless hedge?

    Couldn't it cach fire? OK Chris, seriously for a moment... you seem pretty clued up on this. Explain in simple words, for an idiot scientist in computing and physics, what does all that financial mumbo jumbo mean?

    I'm sure it's just a lot of fancy words to talk about something you could summarise in a few words of plain English.

    I researched Black-Scholes and found only more opaque nonsense written in the same style, which I can only assume is deliberately elitist obfuscastion.

    Or call me an idiot. I don't mind :)

     

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  4.  
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    Pele Payday, Dec 14th, 2006 @ 2:09am

    Mid Season Transfers

    The misanthropic humanist clearly doesn't get it. Lets try again.

    The SEC has accused C. Renaldo of diving, which we know he does not do, it's just that there are more frequent stumbles at the very fast pace of the technology industry. Still stockholders are skeptical of the lightning quick stepovers - something must be done.

    Sir Alex Ferguson has defended C.R. in the press, though you'd expect as much given the Terabytes he is paying to have CR on his team.

    The trick, of course, is to find the Beckhams and C. Renaldos as teenagers and invest in them before the public has a chance, but that is hard unless you are as big a VC as Man U.

    Scholes is a great player, but not so great that any team could base a whole side on. To be competitive one will need better advantage. Google is exploring other line ups to try to give its very employees the attacking opportunities they could have had if they had been on AJAX's youth side, while investors ignore it all and blast down field like Wayne Rooney on the counter, in full belief the ball will find the back of the net even at $1000 per share.

    This is not even a topic of discussion at Big Blue (Chelsea) who get all the talent money can buy, then play conservatively. But Google does not play the game that way.

    Utimately it is all about how well a side passes the ball around, creates opportunities, and finishes.

     

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  5.  
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    misanthropic humanist, Dec 14th, 2006 @ 2:36am

    riskless hedge?

    Couldn't it cach fire? OK Chris, seriously for a moment... you seem pretty clued up on this. Explain in simple words, for an idiot scientist in computing and physics, what does all that financial mumbo jumbo mean?

    I'm sure it's just a lot of fancy words to talk about something you could summarise in a few words of plain English.

    I researched Black-Scholes and found only more opaque nonsense written in the same style, which I can only assume is deliberately elitist obfuscastion.

    Or call me an idiot. I don't mind :)

     

    reply to this | link to this | view in thread ]

  6.  
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    misanthropic humanist, Dec 14th, 2006 @ 4:04am

    Re: Mid Season Transfers

    I think if Google try for an agressive line up this season they could be
    pushing the boat out too far. Page and Brin working opposite sides of a 3-5-2 can be lethal because once Sergey has seen the keeper off his line and decided to pop one in it's all over. But Wall street and the City aren't seeing those robust midfield tangles as opportunity making, every time they come out with all cylinders flying it's a potential bannana skin. I think Ronaldos future depends on the ASA investigation of irregularities at the 20m springboard event last season. Of course fresh blood in the line up creates a new tin of beans, one that the granny bothering spud faced nipper could open with his left foot. But is this fiscally shrewd in an end to end game? After all, you don't want to be giving away free kicks in the penalty area in your first quarter. Down at Stamford Bridge however I think that the Big Blues under Mourinho won't be pulling any new rabbits out of the net, so it will be Samson and Goliath all over again, although an uneven field is a great leveller. If he stays on home form Scholes mercurial moves and fantastic finishing footwork are sure to find space in the box, the Blues will be seeing stars and and Google will be over the moon. Anyhow, the way I see it both sides have scored a couple of goals, and both sides have conceded a couple of goals but at the end of the day it's a game of two halves, and either side could win it, or it could be a draw. It all depends on who wants it more.

     

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  7.  
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    Anonymous Coward, Dec 14th, 2006 @ 5:17am

    This article womps

     

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  8.  
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    Evostick, Dec 14th, 2006 @ 8:14am

    An accountancy story - not a tech story

    Employee stock options allow empoyees to purchase shares at a future time (say 1 year) for a fixed price (say $3).

    If the future market price (1 year from now) for those shares is above that fixed price (let say in1 year the shares are worth $4) then each employee stock option has value ($4-$3=$1). Once they own the share they can sell it back to the market for an imiediate profit.

    If the future price is below the fixed price (say $2) then the emplyee would be buying a share for more than it's worth in the market (in this example, the employee would loose $1 for every stock option exercied). Therefore the emplyee decides not to use the stock option.

    The scheme encourages employees to work hard so the share price grows and they can cash in.

    Google is allowing employees to sell these options before they expire. Sort of distroying the reason for thscheme in the first place. You may as well give the employee a shorter period stock option, or the cash.

    Black scholes is one of the ways used to value how much you would pay for this employee stock option on the open market. There are others, but Black scholes is the simplest model that gives resonable acuracy.

    This artical is about fiancial reward, not about technology. probably here just becuase they involve tech companies. The only controvisy is over account practices. What number should be disclosed - quite boring really.

     

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  9.  
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    misanthropic humanist, Dec 14th, 2006 @ 8:36am

    Google 1 Accountants 0

    Actually very interesting, thanks for explaining it Evostick. I think the language they use is deliberately "in-speak" for financial people. Now I sort of see how this relates to accounting if someone is trying to put a value on something that isn't concrete at all.

    It's surprising that Google and their employees get into such a complex arrangement, but i guess this sort of payment must be more common in the states and people understand stock options and whatnot. To me simply working for a great wage at a world class research lab would be incentive enough. Are you sure this is entirely a way of "rewarding" hard work and not also a way of spreading risk to the employees?
    Cheers.

     

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  10.  
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    SkepticBlue, Dec 14th, 2006 @ 9:55am

    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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  11.  
    identicon
    misanthropic humanist, Dec 14th, 2006 @ 1:40pm

    Great summary

    Wow! Really wow! Thanks both of ya. I've really learned something here today. Now I understand stock options, or at least the idea. I didn't quite get all the variables in Black-Schole but I understand the purpose of the metric, and most importantly why it matters to some accountants and investors.

    Cheers guys!

     

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