We plotted two different performance scenarios: In one, the stock price increases 15% a year over three years. In the other it decreases 15% a year. For each scenario, we examined the impact on earnings from using two types of accounting: fixed accounting, which values options on the grant date and expenses them over time regardless of changing stock price and options value, and variable accounting, which values and expenses options every year.
Black-ScholesHow it works: Uses formula based on dividend yields, volatility, and other factors to estimate option value.Advantage: Accounts for most factors affecting future option value.Disadvantage: Doesn't discount for vesting and other restrictions, so it overestimates option value.Impact on earnings:If stock increases in value: $66.5 million (fixed), $96.6 million (variable).If stock decreases in value: $66.5 million (fixed), $31.7 million (variable).Verdict: Thumbs down. Companies would overpay for underwater options; formula easily manipulated to boost earnings.
BinomialHow it works: Uses Black-Scholes variables, but assumes options will be exercised when optimally profitable.Advantage: Reflects how options really are exercised.Disadvantage: If company pays dividends, this model results in bigger hit to earnings than Black-Scholes.Impact on earnings:If stock increases in value: $67.3 million (fixed), $97.3 million (variable).If stock decreases in value: $67.3 million (fixed), $31.8 million (variable).Verdict: Thumbs down. No improvement over standard Black-Scholes.
Minimum ValueHow it works: Calculates Black-Scholes value assuming zero volatility.Advantage: Of the Black-Scholes variants, this model requires the smallest earnings charge. When stock tanks, company can escape with no charge by using variable accounting.Disadvantage: No public company stock has zero volatility.Impact on earnings:If stock increases in value: $26.4 million (fixed), $69.3 million (variable).If stock decreases in value: $26.4 million (fixed), $472,230 (variable).Verdict: Thumbs down. Pure fiction.
Growth & DiscountHow it works: Instead of volatility, this method relies on assumptions of future stock gains to determine option value.Advantage: Simpler than Black-Scholes, and allows companies that use variable accounting to avoid charge when options plunge underwater.Disadvantage: Difficult to determine future stock gains with 100% accuracy. With fixed accounting, an expensive alternative.Impact on earnings:If stock increases in value: $86.1 million (fixed), $120.7 million (variable).If stock decreases in value: $86.1 million (fixed), $24.4 (variable).Verdict: Thumbs down. Too pricey, and too easy to manipulate.
Intrinsic ValueHow it works: The stock price, minus the exercise price, is the value of the option. Since grant date value is zero, fixed accounting can not be used.Advantage: The simplest method of all, impervious to manipulation, and underwater options are free.Disadvantage: As with any variable accounting treatment, earnings charge could fluctuate wildly with stock price.Impact on earnings:If stock increases in value: $52.9 million (variable).If stock decreases in value: $0 (variable).Verdict: Thumbs up. This method accurately tracks true options value over time. Uses no "assumptions" that can be tweaked to boost earnings. And it's cheap: With stock gains, other methods would result in much bigger charges, and with a depreciating stock, there's no charge at all.
Data: BW; Earnings impact calculated by Towers Perrin
Note: For the purposes of this illustration, BusinessWeek assumed the options were granted on June 30, with the exercise price set at a current stock price of $30, and vested in equal installments on the grant date anniversary in 2003, 2004, and 2005. Calculations assume 40% volatility, 1.5% dividend yield, 1.1 beta, 4.5% risk-free rate, and 10.5% market return. Impact on earnings is the cumulative earnings reduction over three years, not adjusted for taxes.