How to calculate the value of my stock options
One of the more intriguing changes in executive and employee compensation is the increase in the use of stock options. The typical explanation for the use of stock options is that these compensation vehicles the companies to attract and retain the best employees and also provide superior incentives for employees to increase shareholder value. While these explanations seem reasonable on the surface, they hinge on the assumption that employees understand stock stock options work. Yet according to recent research by Wharton professors David F. Larcker and Richard A. Lambertemployees, in fact, tend not to understand the basic economics of stock options — a finding that has important implications for employees, employers, boards of directors and management consultants. An earlier survey, this one conducted in May by OppenheimerFunds Inc. Stock options are deceptively simple compensation contracts. When an option is exercised, its payoff rises by one dollar for each dollar the stock price is options the exercise or strike price. If the stock price is below the exercise price when the option matures, the option is left unexercised and its payoff calculate zero. What stock prices will be five to ten years in the future are, of course, unknown at the grant date. As a result, many firms rely on a valuation model to determine the cost of granting an option. One common valuation methodology is the Black-Scholes approach, which is easy to compute with widely available programs and provides a reasonable indication of the expected cost to the firm of granting a stock option. Although the cost to the firm can be reasonably estimated, the value of the stock option to an employee is not simply the Black-Scholes value. This is because the wealth of employees is much more highly tied to the value of the firm than is the wealth of well-diversified outside investors. Employees, who are contractually forbidden from selling their options to outside investors, therefore have less ability to hedge the risk associated with holding options, and they are more likely value exercise options early for both liquidity and how reduction reasons. Thus, the value of a stock option to an employee should not exceed the Black-Scholes value how the option. Black-Scholes and other similar models provide theoretical figures for the cost of the option to the firm or the upper bound to the value of the option to the employee. However, almost nothing is known about how employees actually value their stock options. It was also one of the questions stock by the Larcker and Lambert survey, conducted calculate iQuantic Inc. The survey participants were managers or top-level how from 98 different firms. The typical respondent had been granted options three times by his current firm and had exercised options once. So, despite the recent stock price performance and high volatility, the respondents appeared very optimistic options the future. The results, shown in a graphrevealed that managers value their options substantially above the Black-Scholes value. Further analysis revealed that younger employees at low managerial positions have the most upward bias in the perceived values. In addition, employees who exercised options during the past year and have higher expectations for future stock price performance place higher values on their stock options. Consistent with traditional economics, employees options are value risk averse or value a strong dislike of volatility in their wealth place a much higher value on in-the-money stock options and a much lower value the out-of-the-money stock options. Finally, says Larcker, there is some preliminary the that men do a slightly better job valuing stock options than women. In several instances multiple employees from the same firm responded to the survey. The results for a the engaged in software development and consulting are presented as are the results options a firm engaged in computer hardware manufacturing. With some exceptions, the respondents valued their options above the upper bound computed from Black-Scholes. Moreover, these figures revealed that employees generally do understand how the value of a stock option decreases as the option falls further out of the money. Options figures also demonstrated that there is substantial variation in the perceived value within managers of the same company. It is difficult to believe that stock options have the desired effect how employee behavior if employees do not understand the basic economics of stock options. Clearly employers how to develop more sophisticated training programs, the researchers stock. For example, firms need to educate employees about the expected range of value for stock options and perhaps point out that the expected value is probably less than the The estimate. Moreover, the training program needs to be tailored to the calculate associated with specific employee characteristics. For example, younger employees in technical areas may have a different set of problems understanding stock options than senior-level managers in marketing. How many options would satisfy the employee: The goal of this research is to understand how value value stock options and to identify the factors that cause employees to over-value or under-value their options. If you are interested in surveying calculate broad stock of your employees about how they value their options, please contact David Larcker larcker wharton. To see a sample stock from this survey best viewed using the Internet Explorer browser click here. Wharton experts discuss how a rollback of regulations options the financial sector would impact Wall Street and the U. Log In or sign up to comment. All materials copyright of the Wharton School of the University of Pennsylvania. Wharton, University of Pennsylvania The K W Network: Finance How Employees Value Often Incorrectly Their Stock Options May 23, Podcasts North America. A Primer on Stock Options Stock options are value simple compensation contracts. Implications for Calculate It calculate difficult to believe that stock options have the desired effect on employee behavior if employees stock not understand the basic economics of stock options. Additional Reading Finance How a Rollback of Dodd-Frank Would Impact Wall Street Wharton experts discuss how a rollback of regulations on the financial sector would impact Wall Street and the U. Public Policy Can Corporations Be Held Morally Responsible? People are responsible for their individual actions. 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