As companies wrestle with how best to value stock options, some are experimenting with using ranges instead of set figures for their assumptions about term and volatility.
Assumptions are significant because they are the basis for establishing a value for stock options, which becomes the basis for the ultimate expense that is charged to earnings.
A study of S&P1500 disclosures by compensation research firm Equilar Inc. reveals that between 6 percent and 7 percent of companies are valuing stock options using a range of values rather than a set value in their assumptions about the term and volatility of their option grants.
Equilar studied filings for 2003 and 2004 to see if the number of companies using ranges was changing–either rising or falling. “I expected to see something more dramatic,” said Tim Ranzetta, president and chief operating officer for Equilar. “I thought we’d see more companies going to a single point number.”
According to Equilar’s figures, 6.6 percent of the S&P1500 companies provided a range of values for their term assumptions, and 6.8 percent provided a range of values for their assumptions about volatility in their 2004 filings. Those figures are virtually unchanged–6.8 percent for term and 6.5 percent for volatility–from 2003 filings.
The practice of using a range instead of a set figure raises questions about the validity of the valuation process for some.
“Using ranges makes some sense for disclosure, where it does not flow through the financial statements, but how would it even work when it is a line on the income statement?” said Cindy Ma, vice president with NERA Economic Consulting, which advocates a more actuarial approach to establishing assumptions, studying historical employee exercise behavior to more precisely pinpoint assumptions. “Have you ever seen a company reporting a range of incomes on its 10-K?”
Ranzetta said companies using ranges for their assumptions would convert those figures using weight averages and plot them into their chosen valuation model. He called it the “black magic” worked out by a corporation’s finance department.
Ranzetta took careful note, however, of a shift that occurred from 2003 to 2004. Only about two-thirds of companies using ranges in their term assumptions did so in both 2003 and 2004. The remaining one-third represented companies who used ranges one year, but not both.
On the volatility side, however, the same shift occurred, but smaller companies tended to stick with the range of assumptions more consistently over both years than did larger companies, the study found. “For volatility assumptions, there does appear to be some association between company size and the consistency with which ranges of values are provided,” the study said.
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