'True' worth of options can vary

July 24, 1994

In estimating the value of stock options, a number of different methods can be used.

Although there is little agreement over which method reflects the truest value of options yet to be exercised, compensation

consultants, accountants, regulators and corporate officials have narrowed them down to a few.

Two of the methods appear in corporate proxy statements required by the Securities and Exchange Commission. One includes an assumption of 5 percent and 10 percent annual increases in the stock price.

A second method, preferred by many regulators, called the Black-Scholes method, attempts to account for the historical volatility of the stock and includes several assumptions related to future interest rates and dividends.

A third method, used by The Sun, makes some of the assumptions of the Black-Scholes method, but simplifies them for consistency.

In the chart at left, the column labeled "Total gain" represents the potential profit for an executive if the company's stock increases by 10 percent per year through the expiration date. That is slightly below the average annual rate of increase of all stocks over the past seven decades. The result of this method is typically the highest valuation.

The column labeled "Estimated present value" reflects a method widely used by compensation consultants to estimate the value of options using a comparison with other current cash payments. The number comes from taking the value achieved assuming a 10 percent annual increase -- contained in the "Total gain" column -- and discounting the increase in its value by 14 percent for each year the option lasts. The discounting represents the risks inherent in predicting future stock prices. The 14 percent rate is based on the average rate of increase of stock prices plus dividends over the past 10 years.

"The idea is to approximate what someone would pay today" for an options grant, said Ira Kay, a compensation consultant and author who is director of the executive compensation consulting division of the Wyatt Co. in New York. "A stock could go up much more or less than average, and you need to add in that risk so that you can compare it to current cash compensation."

Baltimore Sun Articles
|
|
|
Please note the green-lined linked article text has been applied commercially without any involvement from our newsroom editors, reporters or any other editorial staff.