1. Valuation of Employee Stock Options George Montgomery, CFA, FRM Montgomery Investment Technology, Inc. Radnor, PA Phone: 610-688-8111 www.fintools.com

2. Accounting for ESOs FASB’s stated goal was to improve disclosure of employee stock options: “to level the playing field” APB 25 only required the Intrinsic Value calculation FAS 123 “encourages” companies to expense options granted using the Black- Scholes, binomial or other appropriate model

3. www.fintools.com FAS 123 Compromise ruling after 11 years of evaluation and debate Companies do not have to expense option grant value Only a footnote disclosure is required Flexibility in determining inputs to option pricing model allowed: time to expiration and volatility

4. www.fintools.com Standard Option Valuation Black-Scholes Modified Black-Scholes Binomial Flexible Binomial CEV Volatility benchmark from historical prices Interest rate data from Federal Reserve

5. www.fintools.com Non-Standard Options Barrier (Knock-in, Knock-out) Average Price (dampens volatility) Spread (out-performance, index) Stepped-strike Some “closed-form” solutions exist Monte Carlo simulation is often used for more complex contracts

6. www.fintools.com Hedging Exposure Some companies have opted to hedge the exposure that is created when stock options are granted Some investment banks are willing to take on the risk The cost of hedging might seem high to some companies: does that mean that the compensation is too high?

7. www.fintools.com Current Issues Transferability Reissue of options after a drop in stock price (company or market related) More targeted incentive objectives Do employee stock options achieve the stated goal? Why does Warren Buffett “substitute a cash compensation plan of equivalent economic value”? (Forbes, May 18, 1998)

8. www.fintools.com END SLIDESHOW To go back to FAS123 page: FAS123