A Model for Valuing Multiple Employee Stock Options Issued by the Same Company

In this paper we develop a model in which up to 30 employee stock options issued by the same firm can be valued simultaneously and demonstrate that standard methods of valuation can result in under-valuation, especially for long-dated options and for options where the proportion of outstanding options is large relative to the number of outstanding shares of equity. We also develop a version of the model to assess the valuation impact associated with employee options that are expected to be issued in the future. Our model indicates that the anticipated issuance of employee options can have a very negative impact on the value of a company’s shares, especially if the market views such options as representing excess compensation to employees. Patrick Dennis is Associate Professor, McIntire School of Commerce, The University of Virginia, e-mail: [email protected], phone: 434-924-4050. Richard Rendleman is Professor of Finance, Kenan-Flagler Business School, The University of North Carolina at Chapel Hill, e-mail: [email protected], phone: 919-962-3188, fax: 919-9622068. A Model for Valuing Multiple Employee Stock Options Issued by the Same Company On July 14, 2002, in the wake of Enron, WorldCom, Global Crossings and numerous other financial reporting scandals, Coca Cola announced a change in its accounting policy to begin using the “fair value” method for expensing employee stock options (ESOs). Since the announcement by Coca Cola, many other publicly-held companies have followed suit. As set forth in SFAS no. 123, an option’s fair value “is determined using an option-pricing model that takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock and the expected dividends on it, and the risk-free interest rate over the expected life of the option.” This definition of fair value is interpreted to mean value as determined by a dividend-adjusted Black-Scholes (1973) or binomial (Cox, Ross, Rubinstein [1979] and Rendleman and Bartter [1979]) option pricing model. According to SFAS no. 123, an option’s fair value, computed as of the grant date of the option, is expensed over the option’s life as it becomes vested. An excellent summary of the accounting treatment of employee options, along with a proposed modification of standard option pricing theory to accommodate current accounting practice, is presented in Rubinstein (1995). Rubinstein argues that current accounting standards for expensing employee stock options may create more problems than they solve. Notwithstanding potential problems in accounting treatment, under SFAS no.123, the employee option expense begins with the calculation of an option’s value using the Black-Scholes or binomial model. Both models are designed to value a single option issued on the stock of a single firm. However, almost all companies that issue employee options have granted, or can be expected to grant, many options with potentially different striking prices and maturities. In principle, the values of all such options should be determined simultaneously, and it is not clear that a standard BlackScholes or binomial model that ignores valuation interactions among options issued by the same firm is adequate. Our paper addresses these valuation issues. We develop a model in which all employee stock options are valued simultaneously and demonstrate that using the Black-