Non-marketability and the value of employee stock options

We adapt the Benninga et al. (2005) framework to value employee stock options (ESOs). The model quantifies non-diversification effects, is computationally simple, and provides an endogenous explanation of ESO early-exercise. Using a proprietary dataset of ESO exercise events we measure the non-marketability ESO discount. We find that the ESO value on the grant date is approximately 45% of a similar plain vanilla Black–Scholes value. The model is aligned with empirical findings of ESOs, gives an exercise boundary of ESOs and can serve as an approximation to the fair value estimation of share-based employee and executive compensation. Using the model we give a numerical measure of non-diversification in an imperfect market.     

Valuing Employee Share Options: Four Australian Case Studies

We take four case studies to illustrate three issues: how ESOs are valued; how the valuation depends on assumptions; and how US proposals to account for ESOs would affect a company's financial profile. We adopt the Black-Scholes options model to value ESOs issued by Brambles Industries, Coles Myer, Tabcorp Holdings and Westpac Banking Corporation. Under the FASB's proposal, after-tax profit is lower and shareholders' funds and assets are higher beginning with the grant date. At the end of the amortisation period, assets and shareholders' funds would be the same as under current practice, but the fair value of the ESOs on their grant date would have been transferred from unappropriated profits to issued capital.     

Employee Stock Options, Equity Valuation, and the Valuation of Option Grants Using a Warrant-Pricing Model

We investigate the use of a warrant‐pricing approach to incorporate employee stock options (ESOs) into equity valuation and to account for the dilutive effect of ESOs in the valuation of option grants for financial reporting purposes. Our valuation approach accounts for the jointly determined nature of ESO and shareholder values. The empirical results show that our stock price estimate exhibits lower prediction errors and higher explanatory powers for actual share price than does the traditional stock price estimate. We use our valuation approach to assess the implications of dilution on the fair‐value estimates of ESO grants. We find that the fair value is overstated by 6% if we ignore the dilutive feature of ESOs. Furthermore, this bias is larger for firms that are heavy users of ESOs, small, and R&D intensive, and for firms that have a broad‐based ESO compensation plan.     

What determines early exercise of employee stock options in Australia?

Employee stock options (ESOs) are a popular way of remunerating employees. We analyse factors at the firm and option level affecting the employee's decision to exercise ESOs before they mature. Exercises over the period 1998–2004 are analysed and the key factor influencing early exercise is found to be dividends. Exercises frequently occur well before maturity, but in most cases little time value is sacrificed. Our findings have implications for the ‘fair’ valuation of ESOs in companies’ financial statements, as required by the relevant Australian accounting standard, AASB 2.     

Accelerated Vesting of Employee Stock Options in Anticipation of FAS 123-R

In December 2004, the Financial Accounting Standards Board (FASB) mandated the use of a fair value–based measurement attribute to value employee stock options (ESOs) via Financial Accounting Standard (FAS) 123-R. In anticipation of FAS 123-R, between March 2004 and November 2005, several firms accelerate the vesting of ESOs to avoid recognizing existing unvested ESO grants at fair value in future financial statements. We find that the likelihood of accelerated vesting is higher if (1) acceleration has a greater effect on future ESO compensation expense, especially related to underwater options, and (2) firms suffer greater agency problems, proxied by fewer blockholders, lower pension fund ownership, and top five officers holding a greater share of ESOs. We also find a negative stock price reaction around the announcement of the acceleration decision. Furthermore, stock returns are significantly negative before the new vesting dates and positive afterward, suggesting that vesting dates could have been backdated.     

Discussion of “Which approach to accounting for employee stock options best reflects market pricing?”

The objective of the Landsman, Peasnel, Pope and Yeah paper (in this issue) is to compare, for current shareholders, the value relevance of four methods of accounting for employee stock options (ESOs). My discussion provides a unifying framework for the theoretical analyses and the link between the theoretical analyses and the empirical investigation.     

CONVERTIBLE DEBT AND RISK‐SHIFTING INCENTIVES

I argue that convertible debt, in contrast to its perceived role, can produce shareholders’ risk‐shifting incentives. When a firm's capital structure includes convertible debt, every investment decision affects not only the distribution of the asset value but also the likelihood that the debt will be converted and thereby the distribution of the firm's leverage. This suggests that managers can engage in risk‐increasing projects if a higher asset risk generates a more favorable distribution of leverage. Empirical evidence using 30 years of data supports my argument.     

Managing Employee Stock Option Expense: A Fair Value Approach

Owing to special characteristics, classic option pricing models are not well suited to the valuation of employee stock options (ESOs). This paper attempts to conduct a more general fair value estimation based on attaching performance targets to option vesting. Considering a setting that includes factors such as options that may be exercised early at employee discretion, employee exit rates and firm default risk, this paper presents a sensitivity analysis and empirical tests of option value. The results highlight the importance of considering the characteristics of ESOs in the design of performance‐vested option plans so as to provide the most attractive incentives for employees.     

ESO compensation: The roles of default risk, employee sentiment, and insider information

This paper derives a pricing model for employee stock options (ESO) that includes default risk and considers employee sentiment. Using ESO data from 1992 to 2004, the study finds that the average executive's subjective value is about 55% of the Black-Scholes value. Only employees who over-estimate firm returns (or insiders who know that the firm is under-valued) by about 10% per annum will prefer ESOs over cash compensation. Our model also shows that work incentives offered by ESOs may be far lower than those implied by Black-Scholes but that ESOs may induce less risk-taking behavior, contrary to typical moral hazard arguments. Findings may impact relevant accounting regulations as well as compensation decisions.     

How Might Companies Value ESOs?

There has been a steady growth in the use of employee equity compensation plans, and in the use of executive stock options (ESOs) in particular, along with a rise in shareholder and public perceptions that the values of compensation plans are not always fully disclosed. The IFSA of Australia recently called for separate reporting in financial statements of numbers and values of ESOs. Companies, when negotiating employment contracts, frequently agree to compensate an executive if a share option plan is subsequently not approved by shareholders. These facts suggest that reporting the value of an ESO plan is a useful and important exercise. We outline a model for the valuation of ESOs typically issued by Australian listed companies and illustrate the application of the model with a case study.     

Deposit insurance, bank regulation, and financial system risks

Empirical evidence is presented to show that in modern times banks can hedge liquidity shocks but could not do so prior to FDIC insurance. However, the government's limitations in properly pricing FDIC insurance are leading to many current examples of moral hazard. A model is presented to show that if insurance premiums are set to be “actuarially fair,” incentives for banks to take excessive systematic risks remain. Motivated by empirical evidence that money market mutual funds also can hedge liquidity shocks, I consider an alternative government insurance system that mitigates distortions to risk-taking yet preserves liquidity hedging and information synergies.     

Repricing and employee stock option valuation

A repricing occurs when the issuing firm resets the strike price of an employee stock option (ESO). ESO repricings occur most frequently following a significant decline in the underlying stock price. Typically, the strike price is reset to the new stock price. We develop a new model for valuing ESOs with a repricing feature. Our valuation model is developed within a utility-maximizing framework that accounts for potentially multiple repricings, employee risk aversion, employee non-option wealth, the non-tradeability of ESOs, and the early exercise feature of ESOs. Simulations suggest that these factors can significantly affect ESO value.     

Bank Failure,Mark‐to‐market and the Financial Crisis

This paper is concerned with the allegation that fair value accounting rules have contributed significantly to the recent financial crisis. It focuses on one particular channel for that contribution: the impact of fair value on the actual or potential failure of banks. The paper compares four criteria for failure: one economic, two legal and one regulatory. It is clear from this comparison that balance sheet valuations of assets are, in two cases, crucial in these definitions, and so the choice between ‘fair value’ or other valuations can be decisive in whether a bank fails; but in two cases fair value is irrelevant. Bank failures might arise despite capital adequacy and balance sheet solvency due to sudden shocks to liquidity positions. Two of the most prominent bank failures cannot, at first sight, be attributed to fair value accounting: we show that Northern Rock was balance sheet solvent, even on a fair value basis, as was Lehman Brothers. The case study evidence is augmented by econometric tests that suggest that mark‐to‐market accounting has had only a very limited influence on the perceived failure risk of banks.     

Valuing and pricing IPOs

This paper investigates how underwriters set the IPO firm’s fair value, an ex-ante estimate of the market value, using a unique dataset of 228 reports from French underwriters. These reports are issued before the IPO shares start trading on the stock market and detail how underwriters determined fair value. We document that underwriters often employ multiples valuation, dividend discount models and discounted cash flow (DCF) analysis to determine fair value but that all of these valuation methods suffer from a positive bias with respect to equilibrium market value. We also analyze how this fair value estimate is subsequently used as a basis for IPO pricing. We report that underwriters deliberately discount the fair value estimate when setting the preliminary offer price. Part of the intentional price discount can be recovered by higher price updates. We find that, controlling for other factors such as investor demand, part of underpricing stems from this intentional price discount.     

再论经理人股票期权的会计确认

谢德仁和刘文(2002)提出了经理人股票期权会计确认的利润分配观。本文在此基础上进行进一步论证,认为经理人股票期权赠予交易的经济实质是股东为激励经理人而将部分剩余索取权(在财务会计意义上就是利润分配权)让渡给经理人,而不是经理人直接用服务来交换股票期权,经理人股票期权赠予并不以经理人服务的投入为必备前提,经理人股票期权赠予交易内含的价值运动是具有一定价值的剩余索取权(所有者权益)从现有股东那里来,流到经理人处去。因此,在经理人股票期权赠予交易的会计确认上,应将经理人股票期权的对应项目确认为企业的利润分配。     

Two Extensive Margins of Credit and Loan‐to‐Value Policies

We analyze a model of mortgage markets, housing tenure choice, heterogeneous agents, and default with closed form solutions. We uncover new insights which may inspire empirical work, and we ground already established insights in a series of tractable expressions. Then we study optimal loan‐to‐value (LTV) regulation and show that the choice of an LTV cap should balance the opposing forces of access to homeownership and the negative externalities associated with default. Homeownership affordability concerns induce procyclical elements into optimal regulation which attenuate the countercyclical regulation justified by the negative default externalities.     

CREDIT SPREADS AND THE ZERO‐COUPON TREASURY SPOT CURVE

We examine the relation between credit spreads on industrial bonds and the underlying Treasury term structure. We use zero‐coupon spot rates to eliminate the coupon bias and to allow for a consistent study both within and across the different credit ratings. Our results indicate that the level and slope of the Treasury term structure are negatively correlated with changes in the credit spread on investment‐grade corporate bonds. We also find that the relation between credit spreads and the Treasury term structure is relatively stable through time. This is good news for value‐at‐risk calculations, as this suggests that the correlations among assets of different credit classes are stable; therefore use of historic correlations to model spread relations can be valid.     

Which approach to accounting for employee stock options best reflects market pricing?

We use a residual income valuation framework to compare equity valuation implications of four approaches to employee stock options (ESOs) accounting: APB 25 “recognize nothing”, SFAS 123 (revised) “recognize ESO expense”, FASB Exposure Draft “recognize and expense ESO asset” and “recognize ESO asset and liability”. Theoretical analysis shows only grant date recognition of an asset and liability, and subsequent marking-to-market of the liability, results in accounting numbers that capture the dilution effects of ESOs on current shareholder value. Out-of-sample equity market value prediction tests and in-sample comparisons of model explanatory power also support the “recognize ESO asset and liability” method.     

VALUATION OF EVENT‐CONTINGENT OPTIONS

I study a new class of investment options, event‐contingent options. These are options to invest and divest in projects that are dependent on other projects of the same firm or that are conditioned by projects of other firms in its value chain. I construct payoff functions and derive closed‐form solutions for the value of options to invest contingent on investment (OICI), options to invest contingent on divestment (OICD), options to divest contingent on divestment (ODCD), and options to divest contingent on investment (ODCI). I also derive analytical comparative statics for these option valuation equations and examine their implications on the firm's wealth. I offer examples of event‐contingent options in a global context.     

Composition of wealth,conditioning information,and the cross-section of stock returns

Value stocks covary with aggregate consumption more than growth stocks during periods when financial wealth is low relative to consumption. However, the conditional value premium does not exhibit such countercyclical behavior. Consequently, a one-factor conditional consumption-based asset pricing model can be rejected without making any arbitrary assumptions on the dynamics of the price of risk or the conditional moments. Empirical evidence is somewhat more consistent with a consumption-based model augmented with an aggregate wealth growth factor, which can be motivated by either recursive preferences or relative wealth concerns.