Yes, employee stock options can be valued: recent history can provide clues for valuing employee stock options (ESOs). In fact, some experts say they can be modeled much like mortgage securities.

• Author: Sinnett, William M.
• Position: Stock Options

Raise the subject of employee stock options (ESOs) to a group of financial executives, and you're likely to stir strong opinions: "They can't be valued." "How can you value something that is not traded in an open market?" "Why would you want to value them?"

Answering the last question is easy: The current move to provide more transparency in financial reports appears likely to result in companies being required to account for ESOs as an expense on their financial statements.

The answer to "how" may seem problematic, but based on "Valuing Employee Stock Options: A Comparison of Alternative Models," a recent study conducted by Financial Executives Research Foundation Inc. (FERF) and Analysis Group/ Economics (AG/E), it's not as difficult as some make it out to be -- and recent history provides clues to a solution.

"The financial community has already solved much more complicated problems than the valuation of employee stock options," says the study's author and lead researcher, John Finnerty, principal at AG/E and professor of finance at Fordham University.

Indeed, this situation mirrors the concern many had about mortgages back in 1979. Then, during the early 1980s, investment bankers began packaging them into different classes of mortgage pass-throughs that could be bought and sold like bonds. These asset-backed securities became known as "collateralized mortgage obligations" -- CMOs.

The value of these securities was based on the right to cash flows from mortgage payments, which include both interest and return of principal. To get around the problems of defaults, prepayments and variable long-term interest rates, investment bankers collected publicly available data on mortgage prepayments and defaults. From this data, they could then make certain assumptions about the relative probabilities of future cash flows.

Fast-forward to 2003: the mortgage-backed market has grown to more than $4 trillion outstanding, with as much as 70 percent of all mortgages now "securitized" into over 30 classes of asset-backed securities, including fixed- and adjustable-rate residential mortgages, commercial mortgages, automobile receivables and motor home loans.

Is It a Case of "Apples and Oranges?" Why compare mortgages with ESOs? To start, why not compare ESOs with publicly traded options, or exchange traded call options?

An exchange-traded call option gives the buyer the right -- but not the obligation -- to purchase an underlying security at a given strike...