Does you company have options traded on the markets? If so, copy/paste what a comparable option there is worth. This is kind of like saying “I have no idea what my Microsoft stock is worth because I’m not sure how the company will do in the future.”
I guess I’m not being clear enough: my point is it’s not “impossible” to define what an option is worth any more than it’s impossible to define what a stock is worth. It’s mostly future earnings, so it’s the market’s best estimate. Why you can’t put “comparable options to the ones we have outstanding cost X on the open market” if they’re out there is beyond me - and if you don’t have comparable options on the market, use Black-Scholes, because it’s a fairly accurate way to estimate market prices given current knowledge of earnings and whatnot. I don’t see why this turns into a blizzard of unknowability assertations every time it comes up.
Define what a stock will be worth over the next 10 years. Highs and lows. That’s what you have to do to predict the actual worth of the options that you give out today. It’s really that simple. Black-Scholes is the crutch we use because no one can predict the stock price range over the life of the option (usually 10 years) nor what people will sell it at. And no accounting folks that I know have any belief that the numbers it cranks out to expense the options going out today have any connection with the reality of where those options will be exercised. It is precisely as simple as that.
It’s also what you have to do when you predict the future value of a stock - and you have to predict the future value of a stock to predict the current value of a stock.
I’m really not seeing how options are different when there’s a market out there assigning current values to both. Sure, options have a higher variance on future ROI outcomes than the stocks, since you’re effectively betting 100% on future earnings instead of 50% or whatever the NPV of future earnings is for a stock, but I don’t see how that leads to discussions like this where they’re oh-so-hard to value.
Edit: Oh, I just thought of a good comparision.
Some companies hold stock of other companies as an investment - it’s listed at the current price as an asset. That current price is defined by the market value of the stock. No one thinks this is silly; the market’s assessment of value is the best available.
How is it different when a company lists an option that it’s granted to an employee, if a comparable option is publically traded?
No one pretends to predict the value of a stock 5 or 10 years from now in current valuation. Think back 10 years ago. 1996. Clinton was finishing his first term as president. Think of the world situation then, think of any number of companies then and their value now. Would you have predicted that Google would have a market cap greater than G.E.? Think of the impact of the trade center attacks on the economy and the burst of the dot com bubble. Go back and try to predict specific stock prices (and thus option values) in 1984: predict the fall of the iron curtain and the global economic impact. Predict in 1984 what will happen with the internet in the next 10 years and how it will change so many business models and businesses. I’m looking at a company report from a “futurist” that we hired as a consultant in 1984 to help us determine future trends and thus where to invest R&D dollars for the next 5 to 10 years. He was 90% wrong across the board, as were most people. No B-S model can predict any of that.
Um - you do understand the fundamental difference between traded options and ESOs, right?
I’m not an accountant, so I get this from people who are: Black-Scholes estimates the fair value of an option. It is a theoretical model that makes several assumptions, including the full tradability of the option (that is, that the option can be exercised or sold at the option holder’s will) and a constant volatility throughout the option’s life. If the assumptions are correct, the model is a mathematical proof and its price output must be correct.
But strictly speaking, the assumptions are probably not correct. For example, it requires that stock prices move in a path called a Brownian motion–a fascinating random walk that is actually observed in microscopic particles. Many studies dispute that stocks move only this way. Others think Brownian motion gets close enough and consider the Black-Scholes an imprecise but useable estimate. For short-term traded options, the Black-Scholes has been extremely successful in many empirical tests that compare its price output to observed market prices.
There are three key differences between ESOs and short-term traded options. Technically, each of these differences violates a Black-Scholes assumption–a fact contemplated by the accounting rules in FAS 123. Their rules included two adjustments or “fixes” to the model’s natural output, but the third difference–that volatility cannot hold constant over the unusually long life of an ESO (yet this is a fundamental premise in Black-Scholes) --was not addressed.
There’s much, much more, but trying to equate the actual value and predictibility of value of an ESO is significantly different from a traded option, deferred stock (which, by the way, could fundamentally cause the stupid decisions you’re worried about for precisely the same reason as options), etc. There’s a reason people are going into open form models and away from closed form (B-S is closed.) Even with those, a lot of factors are not taken into account because there’s no good way to deal with them.
More than I’m sure anyone really wanted to hear. ;)
So, uh, people buy stock and hold on to it for ten years on a lark? People invest in tiny companies today hoping they’ll get back in the next year, but not the next 5 years? This is a ridiculous discussion; why do companies issue bonds with a term longer than a year?
Yes, I know there’s contentious research in this area. Yes, B-S isn’t perfect. Do you have a better way to value options? Note “don’t value them” isn’t an acceptable answers; companies spent the 1990s showing they can’t be trusted to do that.
How about when you buy stock in a company today you have to pay the capital gains tax on it today? We’ll use a formula that predicts what price you’ll get for it. This IS a ridiculous discussion - in none of the examples above does anyone have to take a financial hit based on some formula that predicts what the price will be in the next 10 years.
Actually, you don’t have to pay capital gains until you sell a stock.
If options are future earnings are so impossibly hard to predict, why don’t companies just pay entirely in options? I really don’t get it; I read what you’re saying as “options are very difficult to value, everyone wants them anyway, and they implicitly don’t cost companies much”. I really don’t see how that set is consistent.
Re. your first line: I know, the reason is that you don’t know how much you will make on the stock until you sell it. My point was that if you can predict the price of a stock and the profit (or loss - I lost a lot of money when the market crashed on some really promising biotech and networking stocks) why not have people just pay the tax as soon as they buy the stock, with some formula telling you what you will make or lose? That’s what you’re doing with companies expensing ESOs at the time of issuance.
Some companies pay a high percentage in variable pay. One company that I work with in Taiwan, one of the biggest chip foundaries in the world, has traditionally paid their people in options and variable bonuses with a very low base pay, such that they made a ton some years and next to nothing in other years. We’ve hired a few of their people who don’t like the volatility. But the reasons companies don’t pay entirely in options and the reason that most companies actually restrict who they give their options to is two fold. First, people DON’T want options in the place of pay - they understand that they are lottery tickets and treat them as such. Great if the company does well, if we get that elusive huge account that no one expects us to get that bumps the stock price, but I can’t plan on paying my kids’ college with them. I can’t plan anything based on the options I have. I can just hope the company does really well AND that results in the stock moving significantly above the issue price. The main reason you give out options is for employee retention, which is why you only give them to your top, critical employees. If you have thousands of options accumulated and leave the company, you lose all of those. They may end up being worth nothing, but you have to consider that if the stock makes a major move, you may have left behind a major chunk of cash. People do leave and forfeit them, but there’s a reason ESOs are called silver handcuffs.
Your worthless ass is easy to value. Stock options, however, are not. People want them because they want to share in any growth in the company they work for – if they help to make the company a success, they should share in that success, and it is relatively easy for a company to offer that participation interest because it doesn’t require any outlay of cash. Options align the interests of employees with the stockholders of the company, and cost the company nothing from working capital.
Their value is entirely contingent on the future performance of the company, the perfomance of comparables in like industries, the overall performance of the market as influenced by national and international events, the likelihood of acquisition or a bid, etc., whether the employee stays at the company (voluntarily or otherwise) long enough for options to actually vest, whether the company is around long enough for those options to vest, etc.
Certainly a lot of options are issued that turn out to be valueless – basically every time a company’s stock price goes down, all options that were issued while the company’s value was higher become valueless.
Which is exactly why it is not legal to make representations of the future value of stocks – such projections are too likely to be materially misleading to potential investors.
Uh, these options are never publicly traded. You are obviously confused about option derivatives, as opposed to incentive options. It is very apparently you are way over your head in this discussion.
To be fair, I do not think he was saying ISOs and NQOs are publicly traded, I think he was saying that we can value publicly traded calls, so we should be able to value ISOs and NQOs with comparable terms, at least in those entities that have an active public market for their derivatives.
I am not saying that I agree with him, just (for some odd reason) clarifying what I think he was saying.
