Options get to stir the juices once again


MYRON S. Scholes learned how to bottle uncertainty and sell it in about 1970, but at first the world paid no mind.

With mathematician Fischer Black and fellow economist Robert C. Merton, Scholes developed an algebraic formula that could spit out a price for the right - but not the obligation - to buy or sell something at a date months or years away.

It seemed impossible. The Black-Scholes calculation claimed to see into time and the investor's mind simultaneously, distilling future ambiguities into present hard cash. The idea was so far-fetched the professors couldn't find anybody to publish their paper for three years.

Many people are again claiming the Black-Scholes model is nuts, even though it became part of the financial wallpaper and won the Nobel Memorial Prize in Economic Science for Merton and Scholes in 1997. Black died in 1995.

The latter-day doubters do not say the professors' apparatus is wrong for pricing interest-rate hedges and other Wall Street staples. But, for one type of financial derivative near and dear to their wallets, these critics have big problems with the Black-Scholes computation and anything related to it.

"The use of the Black-Scholes formula to value employee stock options can only produce results that are unreliable, inconsistent and unlikely to permit useful comparison" between companies, says Russell B. Stevenson Jr., senior vice president and the top lawyer at Ciena Corp. in Linthicum.

Employee stock options. Remember them?

Blamed for one legal type of alleged 1990s corporate book-cooking, stock options have fallen out of the news lately but remain a topic of blistering disagreement in the pinstripe crowd.

Two weeks ago the Financial Accounting Standards Board voted to consider overhauling the way corporations account for employee options.

Stock options let people buy shares in a company at a particular price at a particular time - or over a range of time - in the future. Intended to spur diligence, they are common compensation at high-tech outfits such as Ciena, which makes fiber-optic telecom hardware.

If a company's share price is $8, an executive might get an option to buy 10,000 shares at a "strike price" of $8. If the stock goes to $15, the employee can exercise the option to buy at $8 and then immediately resell at $15, pocketing $70,000 - the difference between $15 and $8 times 10,000.

Stock options can obviously hold great value for employees, but employers have never had to record options as expenses as they do salaries, benefits and other worker pay. Why should they? Options cost an employer no cash. The only downside comes years later when the employer issues new stock to cover exercised options; that dilutes the stake of existing owners.

And yet, the Black-Scholes formula and three decades of experience show that stock options have instant value when issued, long before they're exercised, even if they're "out of the money" with a strike price greater than the price of the underlying stock.

By not subtracting this eminently calculable expense from their revenue, critics say, companies are overstating profits by millions of dollars. The Financial Accounting Standards Board may force corporations to book options as costs, and it's about time, says Scholes.

"They are compensation to employees," he says."Obviously, they should be expensed."

It's not obvious to Ciena's Stevenson and other opponents. They note large differences between employee options and the wheat options and other derivatives that normally get run through the Black-Scholes mill.

Wall Street options can be resold any time in liquid exchanges. Employee options can't be resold ever, to anybody. Vesting periods often keep worker options from being used for years. Employee options are usually forfeited if you leave the company, and it's hard to calculate when employee options will be cashed in. All this probably makes employee options worth less than Black-Scholes says they are, Stevenson believes.

Scholes acknowledges the differences, but he says his formula can be adjusted to account for them, yielding a value that is far more accurate than the "zero" that most companies now record as options cost.

"Corporations give these grants to executives," Scholes says. "They must value them, or why give them to executives in the first place? Second, the models are far more accurate than accounting for depreciation or pensions. Why the noise here?"

The noise? It's mainly from tech companies fearing that apparently inevitable options expensing will stifle reported profits, options issuance and employee gumption all at the same time.

Says Stevenson: "I don't believe in standing in front of an oncoming locomotive, but I have been known to stand by the track and wave a red flag and say, 'Hey, slow down a little.'"

Copyright © 2020, The Baltimore Sun, a Baltimore Sun Media Group publication | Place an Ad