Option Pricing Models

OPTION VALUATION MODELS - The Black-Scholes Model is the preferred method for determining the value of employee stock options ISOs and NQSOs on both publicly traded stock and privately held stock for financial and tax reporting purposes. The FASB and the SEC have both endorsed the Black-Scholes Model for the purposes of calculating fair market value of stock options.

Option pricing models estimate what an option would sell for in the market today (i.e., its fair market value) given the terms of the option and the underlying stock characteristics, including future expectations. The marketplace sets the value of publicly-traded stock, so the value of options to buy this stock can be readily calculated. However, if the company is closely held, the company’s value must first be determined by performing detailed financial analysis of the company and of comparable publicly traded companies. Second, the value attributable to the option must be determined.

There are several widely recognized option pricing models including: Black-Scholes, Whaley, Pseudo-American, Binomial, and Flexible Binomial models. Each of these models are acceptable, but the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) have both endorsed the Black-Scholes Model for the purposes of calculating fair market value of stock options. This model is the preferred method for determining the value of employee stock options (Both ISO and NQSO) on both publicly traded stock and privately held stock for financial reporting and taxation purposes.

The main assumption underlying the Black-Scholes model is that the underlying stock behaves in such a way that future price changes can be modeled by a probability distribution. These modeled future values, along with other variables, are then used to determine the option’s estimated fair market value. These variables include the:

• Underlying stock’s value
• Exercise price of the option
• Underlying stock price volatility
• Dividend expected
• Risk-free interest rate for the option term remaining
• Time until expiration (or the expected life) of the options

It is important to note that the value derived from using this or any model is only as valid as its inputs. When calculating an option on a privately held company, one must first calculate the fair market value of the underlying stock and the assumed volatility of the price of the stock going forward. Slight changes in either of these assumptions can change the value of the options substantially. This is why it is important to value the underlying stock accurately, and estimate the volatility and other factors before applying them to the model.

It is often appropriate to discount the value of the stock underlying the options for various reasons. For instance, non-publicly traded stock should be discounted for lack of marketability. In situations in which SEC Rule 144 applies, the beneficiary is restricted from selling his shares until at least two years from the date of full payment. This restriction also makes a discount appropriate.

Stock option valuations are complex problems requiring critical expert decisions. Every situation is unique, so every valuation should be treated with a fresh perspective using the latest market data. The professionals at Adams Capital have significant experience using the Black-Scholes model to determine the value of stock options.

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