Stock options overview and valuation methods

Stock Options

Payment of stratospheric compensations to the corporate executives by the dot.com companies is the talk of the day. It is pertinent to note that these compensations are paid not only in terms of the cash compensations but also in terms of stock options. However, compensations plans in terms of stock options are not new and being used years together in order to attract the employees and retain with a bondage to the company. The rationale is to give the ownership interest in the company with an expectation that the executive will improve their performances working closely with the share holder interests and the company's long-term profit maximization goals. The stock options as a part of the package for compensating the executives has much more wide spread presently with the cropping up of Internet-based dot.com companies.

The origin of the stock options perhaps traced back to the efforts of the start up companies who being cash poor preferred to pay the executives in terms of stock options as part of their compensation package as they could not afford to pay them competitive salaries. Presently it has become the trend with the success of a handful of dot com companies. The stock options are presently attractive even to the traditional employees for its wealth building potential. Being allured by the success of their counterparts in dot com companies being millionaires overnight, the executives of traditional companies are more anxious to exploit the opportunities. Against this background it is predicted that the continuous boom in stock markets make the stock options to be viewed as a lucrative part of the compensation package. [Among CEOs throughout Corporate America and It's changing The Way Many of Them Are Paid]

Stock Options are a form of contract that confers the right on the executives to purchase a share of stock at a pre-determined 'exercise' price for a pre-determined period. The option revolves around many terminologies such as listed stock, an exchange index, futures contracts, real estate etc. The listed stocks are conveniently grouped as American and European. The American style of option contract allows flexibility for exercising the option contract at any moment of time from the date of purchase to the date of expiration. All the stock options are grouped as American style. Conversely the European style option refers to the option contract that can only be exercised on the date of expiration. The Future Contracts are grouped under the European style of options.

It is customary to designate each and every stock option by the name of the stock associated, the strike price, the expiration date, the payment of premium for the option and also the commission for brokerage. Call and Puts are said to be the most widely discussed options. Owning a call confers one with the rights but not obligations to buy the stocks at the exercised price only before the expiry of the option. And the option has no value once it expires. The writing options allow people to sell options without even having owned them before. When a call is written it is an obligation to sell shares at the pre-specified price at any moment before expiry of the date when called upon. Writing a call option after actually owning the stock refers to Covered Call Writing and conversely, writing without owning the stock is known as Naked Call Writing. Owning a Put confers right to sell a stock at any moment of time before expiry of the option. Writing a put makes it obligatory to buy shares at the strike price at any moment before actual expiry, when assigned. [Stock Options - What is it?]

The stock options have become an important part of executive compensation. Over the past decades most significant changes have been viewed in the sphere of corporate compensation practices in terms of escalations and declines in executive and employee stock options. It has been rightly said that even if the importance of the stock options are growing day by day perhaps this is the reason for it become increasingly controversial. The philosophy behind the stock options is offering of a direct link between the realized compensation and company stock price performance in order to imbibe the executives and employees greater incentive for working in the interests of shareholders. Moreover, the intention behind offering of stock options instead of cash compensation is to attract the highly motivated and entrepreneurial employees and also enable the companies utilizing the services without actually incurring cash expenditure. [The Trouble with Stock Options]

The stock options are so engineered that the executives can only benefit most out of them only with attaching themselves to the firm thus providing an incentive for retention. Besides the stock options also acts as a form of encouragement for executive risk taking. The stock option involves issue of new share by the companies with exercise of option by the employees resulting in the number of outstanding shares. In most of the instances the company offers 'cashless exercise programs' which requires the employee to pay nothing and to receive the value of difference between the market price and the exercise price in cash or in terms of stocks. The gap between the cost and value of stock options are wider, the cost of granting stock options being greater than that of the value that the employee receives. [The Trouble with Stock Options]

The cost calculated in terms of the opportunity cost of the option to the firm is conceived in terms of the amount that the company would have to pay an outside investor in lieu of acceptance of the financial liability of the stock options granted to the executives. Similarly the cost of options equals to the amount that an outside investor pays for the option with assumption of the same exercise and forfeiture patterns of company employees. It is seen that with reasonable assumptions with regards to risk aversion and diversification the value options granted with an exercise price equaling to the market price the employees value the stock options only at about half of their cost to the firm. The value-cost ratio is said to be smaller considerably with options having exercise prices higher than existing market price.

This is also possible when the exercise prices increased over a period of time and when options have a long vesting period. In this way the efficacy of the stock options as a method of providing compensation depends upon the adequacy of the benefits of attraction, retention and motivational forces influencing the employees for justifying the compensating differentials between the cost and value of the stock options. One of the most important potential benefits that the firm expects out of providing compensation in the form of options is the attraction of employees without actually incurring cash expenditure. This benefit actually needs evaluation in terms of the compensating deferential demanded by the option holding employees. With the grant of the stock options the companies defer payments of cash actually involving a borrowing from employees in terms of services in exchange of volatile payouts in future. [The Trouble with Stock Options]

Such compensations in lieu of cash is said to affect the type of employees that the company can attract. Such offerings of stock option will attract only those employees who are highly motivated and entrepreneurial and who have enough confidence on themselves for increasing the stock prices of the company. The justification of this benefit in compensating the differential charged by the employees for accepting risky compensation mostly depends on the availability of the other managerial characteristics. However, it is open to realize that the philosophy attraction behind stock option is mostly confined only to the top managers and some key engineers or technical employees having confident of directly influencing the stock prices.

This portion of the employees only constitutes a small fraction of the holders of the total grant of stock options. A major chunk of the stock option holders in the company are from lower level positions. These stock options can attract only that portion of the total at this level of employees who are relatively less risk averse. The objective of attracting less risk averse employees can better be fulfilled by means of offering bonus plans tying to performance measures which provides both sorting and incentive while the stock options only provides sorting but not incentive at this level. Thus justifying the objective of attraction is not fruitful in case of stock options. It can attract only a top managerial class but fails to provide incentive to the lower level of employees. [The Trouble with Stock Options]

Another objective of stock options is to ensure Retention incentive of course putting restrictions with provisions for forfeiture of the unvested stock options with the leaving of the employee. Such incentive for retention by the stock options is said to be highest only when the exercise price of the options are sufficiently above the exercise price in order to induce the employee to remain in job before being actually able to exercise the option. The vice versa in the pricing of the stocks result in 'under water' and render the objective futile particularly at a moment when the substitute employers offer new grant of more valuable options. It is a general consensus that the stock options provide retention incentives but the efficacy with which it operates is under question. They may be several other alternative compensation mechanisms ensuring employees stay with the company.

The deferred compensation or pensions or by progressively increasing the payment with their increasing stay are several such alternatives. In case of the risk-averse employees cash is more valuable than the stock options these alternatives are more effective in terms of the retention incentives and also cost effective. Moreover, there are no justifications for optimally varying the retention incentives with variation in the company stock prices. This leads the workers finding it advantageous of staying with the company in a Bull market and to shift to another employer in an environment of bear market. Firms try to overcome this stage of underwater options by altering the compensations the executives so as to make them find it worthwhile to stay with the company forgoing the offerings of alternative companies. However, it has its own disadvantages as it gives an impression of rewarding poor performance. [Sink or Swim: Firms' Responses to Underwater Options before and after the Accounting Change for Stock Option Reprising]

The next objective behind the stock options is to ensure motivational incentive that tie up the top-executives motivating for increasing performance of the company stock. However, it has its own limitations. It is generally seen that about 90% of stock options are granted to the low level employees and therefore, its efficacy in imbibing motivation for improved performance is still under confusion. It is argued that only an insignificant portion of the total outstanding shares are held by the employees. Thus the problem arises as to what will be the share of the gain that goes to the employees even if they increase the value of the firm. This negligible share of the employees on the total gain coupled with the enormous risk that is imposed upon the employees through stock-based pay create every possibility of making the motivational incentive of the employees futile.

Against this the cash based incentive plans seems to provide more efficient pay-performance incentives which is based on objective and subjective performance measures. It is often said that relating the pay with company stock price provides indirectly incentive to the employees for communicating corporate objective of maximizing the wealth of shareholders, increasing morale of the employee, mutual monitoring encouragements etc. However, examples are there for the boomerang of these benefits especially in an environment of bear market. The decreasing stock prices affect adversely the morale of the option holders. [Compensating Employees below the Executive Ranks: A Comparison of Options, Restricted Stock, and Cash]

To summarize in stock option compensating package, the Corporate Executives find an incentive to increase the systematic risk of their stocks to enhance their own wealth. It is found that the risk incentive seems to be stronger with the lowering of the total risk level. The true option value is underestimated by the Black-Scholes formula due to the inability to incorporate systematic risk into pricing, and conversely the true option is overestimated because of the failure in proper accounting return dependency in computing the constant volatile estimate. Thus Stock Options have several disadvantages and cannot fulfill the objective of company to ensure retention, mobility and attracting the efficient employees and corporate executives thereby ensuring growth and improvement of the company it self. This tends to search for other alternatives in the line of compensating. [Executive Stock Options and Incentive Effects due to Systematic Risk]

As is seen earlier the rationale behind the stock options is expectation of companies on corporate executives to align the interests of management with those of shareholders. The trends in the Bull market of the 1990s revealed its loophole of rewarding the top executives with huge amounts of cash from the exercise of stocks even in most of the low performing companies. This necessitated prevalence of performance-based options in order to provide incentives to the executives for outperforming the rival of the company and the market instead of simply rewarded due to a rise in the share price as is in the case of fixed stock options. [Performance-Based Stock Option Proposals]

Many such performance-based options are advocated which includes-- Premium-Based Options, indicating the exercise prices above the fair market value on grant date by the value of the premium ranging from 25 to 100% of the market prices; Performance-Vested Options where in the options are vested in pursuance of certain pre-determined goals in terms of growth in revenue, profits or return; Price Vested Options which are conferred by the reaching of share prices to a designated level; Performance accelerated options, refers to those type of options where the vesting accelerates in geometrical progression after meeting a specific determined target; Performance-contingent awards which envisages forfeiture of awards based on stocks unless the objectives of performance parameters are not attained thereby infusing an element of risk. The most common of all the performance-based options are indexed options where in the exercise price is linked to the market or index of the peer group fixed in terms of relative performance. [Performance-Based Stock Option Proposals]

Indexed stock options, seen as the alternative to standard stock options mainly stems from the disadvantages of latter. It was observed that the corporate profit of socialfunds.com rose to 108% during 1990-98 while the pay of corporate executives rose to 481%. To add with the rise in the average workers pay was only 28%. This is sheer injustice. In the words of Beth Young, "We believe it is inappropriate to compensate senior executives for improvements in company performance that are attributable to factors beyond their control. Examples of such factors are a general stock market rise in response to interest rate changes or a rise in the price of all airline stocks because of a drop in fuel prices." [Indexed Stock Options Reward Performance] This led to great discontentment against the faulty compensation package and led to think of the indexed stock options. The Indexed stock options are viewed as a method to put the rewards of executives into perspective by linking that with an index that measures the relative performance of the company.

Conversely, the executives are not compensated under the package of indexed options unless it is observed that the company outperforms a fixed index. It may be a general index or a peer group index. Thus the indexed option is viewed as a promising method of ensuring more effective motivation by linking the executive compensation to performance. In case of indexed options the exercise price is determined by a set of references to the fixed index and not known at the time of grant of options. To exemplify, an increase in the average share price to the tune of 10% as experienced by the index group results in the fixation of exercise price at 10% above the market price as on the date of grant. In this manner the indexed options are viewed as a reward for relative rather than absolute performances. The executives of the company are deprived of the compensation unless the stock of the company reaches the specified index. This criterion makes the options comparatively less valuable in a bull market however, at the simultaneously safeguards the potentiality for compensation even in a bear environment when the stock of the company declines of course less steeply than that of its competitors.

Indexed Stock Options Reward Performance]

The Chairman of Federal Reserve, Alan Greenspan is a great supporter for the indexed options. Simply a rising market in the stock options package ensures the executives boatloads of cash; however, it will end in dismal future when the market gains continue to narrow. By means of indexed options the companies guarantee huge paydays for the real executive superheroes. This led the Robin A. Ferracone, the Chairman of pay consultant SCA consulting to remark that "Indexed Options hold the executive to a higher standard." [Commentary: An Options Plan Your CEO Hates] The Indexed Options are said to be linked with the relative performance contrary to the absolute performance. It is a reward of the relative performance. Its relative importance lies in the fact that with the fall of the market no value return is possible in case of traditional stock options while the indexed option ensures pay offs to the executives if the fall in the underlying stock is comparatively lesser than the market.