Volatility and the Valuation of Stock Options Living in the Zone

Stock options are a form of compensation often paid to employees of a company to allow those employees participation in increases in the company’s value. Today, stock options are commonplace as part of incentive compensation packages and the Financial Accounting Standards Board (FASB) has issued standards regarding the amount of remuneration that is currently paid and recognized by the granting company, therefore eligible to be booked as an expense of the company.[1]

FAS 123R requires that options granted must be expensed at their fair value at the time of grant. Option prices for publicly traded companies are often determined by the open market. Determining the fair value of options granted by privately-held companies presents something more of a challenge, however. For privately held companies, fair value must be determined through accepted valuation practice, using the best available information.

There exist a number of financially sound methods for determining the fair value of options issued by private held companies. The Black-Scholes Option Pricing Model, Monte Carlo Simulation and Lattice Models are three commonly accepted methods. The models all require the same basic inputs: the trading price of the underlying stock, the amount of time until the options expire, the option grant price, the volatility of the underlying stock and others. For non-public companies, two of the inputs are not readily available – the price (value) of the underlying stock and the volatility of the underlying stock.

Setting aside the value determination of the underlying stock, which will be discussed in a subsequent newsletter, leaves volatility as the key input that is not easily determinable. If one believes that the historical behavior of the price fluctuations of individual stocks is indicative of future volatility, then one need only look to a stock’s past volatility to estimate the future volatility. But what if the stock has no observable market? In such cases, there is no pricing history to repeat – no readily available pricing data – and, therefore, no calculable price volatility.

In these instances, increasingly common in privately held companies, it is typical for an appraiser to look for some measure of “market” volatility as an indicator of the stock’s volatility. Although the concept makes sense, and is one of the recognized means by which to make the estimate, an appraiser must be careful to be sure that a meaningful comparison is possible. The typical resources available to the appraiser, in this regard, are the major stock indices such as the Dow Jones Industrial Index, the S&P 500 and the like. But the question of comparability arises given the characteristics of many private companies versus the broad makeup of the indexes.

Narrowing the comparable index to an industry-specific index mitigates the problems associated with using very broad indexes but does not address differences in size between the public and private companies. These size and composition differences between the privately held companies and the widely-quoted indexes can be observed in terms of differences in revenue, asset base, profitability, diversification (product and geographic), capital structure and many other characteristics, all which manifest themselves in volatility differences.

Because an appraiser is tasked with finding the best measure of volatility to apply as a surrogate, it would be ideal to apply the volatility observed from an index that is comprised of similarly sized, geographically specific companies within the same industry. Valuation standards require appraisers to consider and apply the best available data when performing valuations. We believe the most comparable indexes (by size, geography and industry makeup) represent that data in the determination of volatility for FAS 123R purposes for companies that do not have readily observable price volatility.

[1} FASB oversees GAAP financial reporting.

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Robert Buchanan

Valuation | ESOP
Orlando Office

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