Five Essentials for Stock Option Valuation

Valuations can be tricky even for vanilla stock options. Here are some of the best practices I’ve seen for modeling stock options so that valuations are neither overstated nor understated.

1. Filter non-representative historical data.

While expected term estimates should be grounded in empirical data, not all data faithfully represent go-forward future expectations. Expected term estimates should be developed based on a careful analysis of representative historical data.

2. Match the expected term estimation model with award attributes.

Multiple methods exist for estimating expected term. The appropriate one depends on how many vesting schedules are used, whether changes have been made to the contractual term, and quantity of historical data available.

3. Identify foreign-filing subsidiaries.

Most expected term estimation methods used for US GAAP purposes are not compliant under IFRS 2. IFRS 2 requires graded amortization, which in turn requires estimating expected term separately for each tranche within an award. This approach has historically been uncommon under US GAAP, although perfectly compliant.

4. Test historical and implied volatility.

The appropriate weighting of historical and implied volatility has changed for many companies. Implied volatility continues to be a powerful estimation approach, but the SAB 107 criteria (option moneyness, trading volume, maturity, and date synchronization with the options being valued) are the subject of increasing audit scrutiny.

Historical volatility may smooth the volatility estimate and capture a steady-state average volatility in the stock. On the other hand, it could create problems for firms that are continuously changing.

5. Test for different exercise or forfeiture patterns.

Our research has shown that whereas only approximately 30% of companies have distinct exercise differences across employee groups, over 75% have such differences in forfeiture patterns.

6. Use a lattice model.

The science surrounding lattice-based approaches has standardized, making these analyses much simpler to perform. In any case, you might have to perform such an analysis under IFRS.

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