Volume 15, No. 13

 

Employee Stock Option Volatility Assumptions:  Real Or Not?  Like it or not, assumptions that are built into much of financial reporting. They're embedded in everything from accounts receivable (how much will never be collected?) to warranty expense (what will be the repair rate on cars sold?) Like it or not, firms can use assumptions to finesse earnings so they meet Wall Street expectations. And like it or not, firms are now required to report stock option compensation for the fair values of option grants - using estimates of underlying stock volatility. In the Black-Scholes model used by many firms, lowering the assumed volatility input will lower the compensation expense to hit earnings. The incentive to low-ball is high. The volatility input is not something that can be observed with great precision; it is, after all, an estimate made by management about the way the firm's stock will behave in the future. At the same time, the changes in the volatility assumption leave a trail of circumstantial evidence as to whether or not management has "grooved" the volatility input to achieve a lower option fair value and compensation expense. Like it or not, it's one more variable that analysts and investors have to consider in the full context of the financial statements. A look at the volatility inputs of the S&P 500 and Russell 2000 provides some background for determining whether or not wishful thinking is behind the input selection.

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