What's the right Black-Scholes value?

• Author: Young, Christopher K.
• Position: Valuation of executive stock options - Corporate Reporting

As the SEC and FASB stock-option initiatives build momentum, it's clear that the special characteristics of executive options, especially vesting restrictions, must be incorporated into the valuation model.

The collective outcry from the government, public and investors over executives' huge option gains has fueled the perception that executive pay in Corporate America is dangerously out of control. As a result of these and other pressures, the Financial Accounting Standards Board and Securities and Exchange Commission have introduced initiatives on accounting for and disclosing stock options, making the need for a credible valuation technique an urgent issue that demands resolution.

The Black-Scholes model is increasingly viewed as the model of choice, but it may not merit this status. Outside the investment community, where it has been used for some time, the model isn't well understood, and crucial considerations like the impact of vesting on option values remain unresolved. In particular, the FASB's current position on recognizing option vesting restrictions is flawed. It recognizes the impact on the value of stock-option forfeitures created by vesting restrictions, but not the loss of the right to exercise the option for the vesting term.

The model was originally developed to value market stock options, but the executive stock option is an entirely different animal. The terms to expiration are typically much longer than those of market stock options. And unlike market stock options, executive stock options aren't transferable and are often subject to restrictions on option exercise.

Proponents of using the model to value executive options think it's the best-available approach because it offers easily obtained, objective inputs, permits the user to calculate values with relative ease and can be applied consistently from company to company without excessive subjectivity. Therefore, proponents skirt some of the problems by adjusting the model's values to recognize the differences between executive stock options and market stock options.

This has ironed out some of the kinks, but other important questions remain. Although the model is easy to manipulate, it is difficult to understand how it really works and what its outputs mean. Other problems are the model's highly restrictive assumptions when applied to executive options and its inability to deal convincingly with the differences between executive and market stock options.

The original...