Most of the grousing about the Financial Accounting Standards Board plan to charge earnings for the value of newly issued stock options is misdirected.
To judge from critics, the biggest concern is the catastrophic impact such charges supposedly will have on the stock prices of option-generous companies like Lotus Development Corp., 3 Com Corp., and Microsoft Corp. This impact, so the thinking goes, will chill these same companies from issuing new options, thus stifling the creativity and entrepreneurial spirit that made their options so valuable in the first place.
While the latter may be true, it will only be because managers not investors cling to the fear that disclosure will wreak havoc on their stock prices. It will not. The proposal merely makes available to retail investors what sophisticated price-setting investors already know from annual proxy materials and reconnaissance.
Were the doomsayers correct, we would expect disproportionately greater short-selling and thus poorer stock price performance among companies most vulnerable to earnings hits. It hasn't happened.
If there are grounds for grousing shout the FASB option proposal, they lie in measurement, not disclosure. To date, the FASB, the Securities and Exchange Commission and most compensation consultants have endorsed the Black-Scholes option-pricing model for quantifying value.
Derived in the mid-1970s to value a fully transferable short-term call on a European-type option for non-dividend-paying instruments, the model has been tweaked, squeezed and reshaped numerous times to conform to non-transferable long-term American warrants on dividend-paying instruments where exercise is contingent on employment and where the holder cannot be expected to behave like a highly liquid well-diversified investor.
If that sounds like a mouthful, it is. To date, no derivative of the Black-Scholes formula has attained consensus as a theoretically or empirically reliable measure of an employee stock option's value. Consequently, it is highly probable that two companies with identical characteristics but different advisers would arrive at different valuations for their options.
Yet, surprisingly, the SEC and the FASB have focused little attention on who conducts the valuations. In most instances, it is the company's compensation consultants, most of whom have little practical experience in financial economics or option trading, never mind the Ph.D.-level physics needed to comprehend the original Black-Scholes derivation. At least with prior changes in accounting rules, implementation lay with accounting firms or actuaries, who, because of their tight internal and external standards, ensured consistent application.
With stock options, the danger we face is that disclosure will be doomed to ridicule at the onset, not because it is a poor idea, but because it is a good idea poorly executed.
If the FASB and the SEC are to ask corporate managers to embrace disclosure, they must reassure them the valuation methodology will be consistent across competitors. This is perhaps more important than accuracy. If the FASB and the SEC cannot ensure consistency, then disclosure will become meaningless as companies scramble to find the most aggressive compensation advisers available and as investors recalculate the entries themselves.
One way to improve consistency is to lodge responsibility for valuation with each company's accountants, not its compensation consultants. This would, in effect, reduce to six the number of competing methodologies used to value any company's options. In practice, it would reduce the number further because most industries are dominated by only two or three accounting firms each. In addition, the accounting profession has a forum, the FASB, for assuring uniformity, consistent training and, one hopes, economic accuracy. Perhaps more important, making valuation an accounting question would eliminate the conflict of interest associated with letting an option plan's author conduct its valuation. Over time, letting accountants conduct the valuation would bring sanity to what will otherwise descend into a free-for-all.
Ultimately, even uniform implementation won't ensure respect for the FASB rule unless the methodology is understandable. All Black-Scholes derivatives defy easy understanding. While the results they churn out can seem sensible, most line managers and executives regard the models as black boxes that can be exchanged for new ones if the results don't square with intuition or earnings objectives.
The only way to ensure respect for the valuation process is to generate understanding. That will occur when the FASB and the SEC stop burrowing into formulas and start encouraging easy-to-grasp simulations. A computer could generate a 60- or 120-month forecast for a company's stock price, assuming certain growth, volatility and dividend characteristics and then present-valuing the amount by which an employee stock option would be in the money upon expiration. If repeated several thousand times (an easy task on desktop computers), the average valuation, excluding instances where the option ended out of the money, will be an unbiased estimate of how much the option is really worth. If conducted over short periods with no dividends, the results will match the Black-Scholes model exactly.
The beauty of the simulation technique is that it is graphically and intuitively clear to line managers how their options are valued. Focus would thus be diverted to parameters managers can comprehend, a stock's expected level of volatility, its expected growth rate given dividend policies and interest rates, and a manager's likelihood of leaving the company before the vesting or expiration date.
Rather than trusting outside advisers and "quanta" to reformulate the already abstruse Black-Scholes model, management can fine-tune the option-pricing experiment to control for almost every variable that makes application of the Black-Scholes model ponderous or inaccurate. And they can do so in a way line managers will understand and respect. In the end, there will doubtless be debate over discount rates, attrition assumptions and the like, but the debate will be informed and will not depend on blind faith in generally incomprehensible and externally defined sets of formulas.
The FASB and the SEC need to recognize the Black-Scholes and derivative models were developed to explain market behavior at a time when the power and accessibility of mathematics far outstripped the power and accessibility of computers. That time has passed. So-called Monte Carlo simulations are now easier and more reliable to run than imperfect modifications of traditional formulas. While the latter always will hold interest to economists as a way of generalizing about the economy and the stock market, the former is more adaptable, understandable and reliable for particular valuation projects. In the end, the simulation approach will prevail, either directly by SEC or FASB endorsement, or indirectly by investors who conduct the analysis themselves to correct the inevitable prolif-eration of valuation blunders.