Managers tend to overvalue stock options vs. restricted stock - 22 Sep 2009
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September 22, 2009
While stock options became a celebrated form of dot-com compensation
during the ’90s high-tech boom, most people today assume they are an
equity incentive offered only to senior executives.
Yet in 2002, more than 90 percent of the stock options granted at
S&P 500 companies were awarded to non-executive level employees.
Recently, some of these firms have switched from awarding mid-level
employees stock options—an option to buy a firm’s stock for a fixed
price during a future time period—to awarding them restricted
stock—stock granted to an employee that cannot be sold until the
employee satisfies a vesting requirement.
But do those employees know how to value equity compensation
accurately? Many do not, according to a study by Frank Hodge, Shiva
Rajgopal and Terry Shevlin, professors of accounting at the University
of Washington Foster School of Business.
Hodge, Rajgopal and Shevlin found that managers, on average,
overvalue stock options relative to their theoretical fair value.
Theoretical fair value is computed using the Black-Scholes option
pricing model, which takes into account a firm’s current stock price,
the option’s exercise price, the risk-free interest rate, the option’s
time to expiration and the firm’s stock price volatility.
No lottery ticket
The study analyzed survey data from 192 current and future
mid-level managers enrolled as executive and day-time MBA students at
the Foster School. On average the managers had eight-plus years of work
experience in a variety of industries; 43 percent had been granted
stock options and 16 percent restricted stock.
In the survey, the average manager:
- assigned a value 29 percent greater than the option’s theoretical value,
- overvalued stock options relative to an equivalent fair value package of restricted stock,
- valued quick vesting and extended expiration dates when valuing options,
- tended to extrapolate recently rising stock prices when valuing both options and restricted stock, and
- often treats stock options like a “lottery ticket.”
“Not surprisingly,” Hodge explains, “managers who report having a
lower self-understanding of how options work are more likely to treat
options in this manner.”
Get financially educated
Hodge says that employees usually learn to value options or
restricted stock from peers. But such word-of-mouth education tends to
spread, at best, information that only proves useful under certain
market conditions. And misinformation can be costly. For example, a
2003 survey by Fidelity Workplace Services found that nearly half a
million US households let valuable options expire from 1999 to 2000.
Firms that switch from broad-based option plans to broad-based
restricted stock plans should pay special attention to educating
employees on valuation, Hodge adds, lest they create unintended,
negative reactions from employees who do not recognize a “fair” trade.
“Our study emphasizes the importance of educating employees about
how to value stock options, something few firms do in any detail,” he
says. “Many firms are hesitant to do so because
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I think managers tend to undervalue ESOs because they tend to use the company's "fair value" calculations which are artificially lower that they should be.
John Olagues
I have seen where Manager's, in general, over value both and view them as a quick fix for just about anything. However, I think it may be more of an undervalue of restricted stock. Since options have been so popular, most employees don't realize that a grant of restricted shares is better than a grant of stock options. In fact, many don't even know there is a difference. While the leverage may not be as great as options, the only cost to the employee is taxes. I have seen employee argue that they have options not restricted shares or complain about not getting options.
I find that how one values options vs. restricted stock depends on the level of manager and the number of shares plus the perceived upside growth of the stock price.
The options' values that are derived for costs purposes using theoretical options pricing models are understated by the companies to show the lowest possible expenses against earnings. The companies do this by using artificially low assumptions of volatility and expected time to expiration.
In my view, the ESOs are more valuable, especially if the ESOs time to expiration is extended by the grantee by his using hedging strategies.
Cheers:
jJohn Olagues
I for one would much prefer a grant of restricted stock over options, as RS cannot expire worthless (unless the company folds).
As for the valuation question, I think there is an inherent bias toward overvaluation in order to get a higher income tax deduction; the expense component is rather meaningless as there is no real expense involved and analysts generally disregard this number when evaluating a company's earnings.
Dear Mr. Buttram:
Thank you for your reply.
However, companies do not write off the "fair value" expense against income taxes. The "fair value" is written off against earnings only. The intrinsic value when the option is exercised is written off for tax purposes but not as an expense against earnings.
The companies want the lowest possible "fair value" calculation and the highest and earliest intrinsic value calculation. That's one of the reasons why premature exercises are encouraged.
john Olagues