Following suit, on July 26, 2006, the U.S. Securities and Exchange Commission (SEC) announced news about additional (and arguably more comprehensive) disclosure rules for all sorts of executive compensation vehicles, including stock options. The SEC plans to provide "additional guidance regarding disclosure of company programs, plans and practices relating to the granting of options, including in particular the timing of option grants in coordination with the release of material nonpublic information and the selection of exercise prices that differ from the underlying stock's price on the grant date."

Now, backdating takes a bow. Described as the practice of granting stock options on one date, and then changing the date of the grant or award date to an earlier time when the stock price was lower, backdating is wreaking all sorts of havoc. While not necessarily illegal, some instances may result in tax penalties, accusations of securities fraud for failure to disclose and financial restatements, respectively. Concerned about alleged misdeeds and an adverse impact on stock price, pension funds are lining up to bring suit.

It is impossible to tackle the merits of any one situation without sufficient information to evaluate a problem, if one exists, and assess economic damages to anyone found to have been harmed by backdating. However, even in the absence of case-specific information, a discussion about the valuation of executive stock options is, nevertheless, worthwhile. Susan M. Mangiero, Ph.D., CFA and Accredited Valuation Analyst, says that “describing the topic of executive stock option valuation as broad is like saying that Lake Michigan is a little body of water. That’s why it will continue to resurface as the topic du jour in court, regulatory proceedings, auditors’ roundtables and board meetings everywhere.”

One important aspect of option valuation is volatility, a measure of future price uncertainty. There are different definitions and measures of volatility. One approach is to statistically assess past performance. Unfortunately, historical price behavior is not always an appropriate bellwether for the future. An industry and its constituent members may have undergone radical change in the form of deregulation or technological innovation. Another measure, implied volatility, is derived by examining market prices of an option (characterized by time to maturity, exercise price and other relevant factors) and backing into an estimate of investors' beliefs.

As written in "Model Risk and Valuation" (Valuation Strategies, March/April 2003), Dr. Susan M. Mangiero describes how the volatility number can have a dramatic impact on the computed value of an option, adding that the relationship between volatility and option value is not proportional. Consider that an increase of ten percent in volatility does not necessarily translate into a ten percent rise in the value of the option. She urges: “This is a simplistic statement, since option value does not depend on volatility alone."

One thing is certain. Estimating volatility should amount to more than a mere number crunching exercise. The process needs to reflect an assessment of economic performance going forward. A mistake in volatility choice can be costly and lead to a slew of unwelcome events.

Written by BVA, LLC, Business Valuation Analytics(sm) an independent full-service valuation and risk analysis firm.