Stock Option Valuation
(Daniel Garcia | Business Valuation Manager)
Retaining talents and aligning company executives’ interests comprises a constant challenge to companies around the world. A benefit and remuneration package companies offer seems to be among the resources to keep good professionals for the long term. In this aspect, it has become ever common to observe the use of stock options as part of executive remuneration, especially in publicly-held companies listed in the stock exchange.
Quite common in the North American market for decades, stock options have become increasingly popular in our ever stronger capitals market. The granting of stock options to executives allows for a certain number of shares, at a pre-established price, be acquired in the future. This device, which presents itself as a right of future share purchase by the executives, seeks to align company and shareholders’ interest with that of the executives. The principle is that the executives endeavor to deliver positive results to the company, so as to reflect these on share value, thereby generating an economic benefit to all parties – shareholders and executives.
Generally, stock options are conditioned to requirements set forth upon their granting, viz., minimum time of permanence in the company, term of exercising, total or parceled exercising stock options, among other criteria which the company and its shareholders deem coherent. Once the conditions set forth have been established, the executives may exercise their right to purchase the shares for a pre-established price upon share granting.
The companies which use stock options as instruments for remunerating and aligning their executives face the challenge of registering them at a fair balance price upon granting of right.
The Accounting Guideline Committee (Comitê de Pronunciamentos Contábeis), through its CPC-10 guideline (Stock-based Payment), defines the procedures to post stock options in the financial statements. The guideline determines that on entity acknowledge stock-based payment operations, including those with employees or other parties, notwithstanding the form of liquidation: in cash or in the entity’s equity instruments (stocks or stock options).
FAIR PRICE DETERMINATION
The company must measure, on the date of stock option concession, the fair value of this instrument based on their market price, when available, and taking into account the requirements and terms agreed with the counterparty.
Thus, in the cases where there is no available market price, the company must use an available and acknowledged evaluation technique, on concession date, to estimate the price of the pertinent stock options granted.
Among the known valuation techniques, the Black-Scholes-Merton formula has been widely used as an option pricing model. Developed by Robert Merton, Myron Scholes, and Fisher Black in 1973, the methodology is widely used to this date, especially by the financial market, for pricing stock purchase options. This methodology displays a wide range of applicability and has created new research areas, even outside financial economics. Derived methods can be used to evaluate contracts and insurance guarantees, or, still, the feasibility of several kinds of projects.
Black-Scholes-Merton’s proposal is determining the price of an option on account of asset price and other known variables, such as share prices, interest rates, contract maturity dates, exercise prices, and asset volatility.
The Black-Scholes-Merton model is appropriate to value, especially, the stock options whose exercise price occurs upon contract maturity. For contracts with complex requirements, which allow for exercising the right prior to maturity, models such as Binomial (BOPM) or Monte Carlo Simulation can be more adherent.
Apsis will help you in case you need further information on stock option valuation.
