THE OHANA GROUP AT MORGAN STANLEY EMPLOYEE STOCK OPTION VALUATION

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1 THE OHANA GROUP AT MORGAN STANLEY EMPLOYEE STOCK OPTION VALUATION BRYAN GOULD, FINANCIAL ADVISOR, PORTFOLIO MANAGER TELEPHONE: (858) La Jolla Village Drive, Suite 1000, San Diego, CA telephone: Morgan Stanley Smith Barney LLC, Member SIPC

2 Overview! Valuation of ESOs is a very complex issue, but it can be simplified for practical understanding. ESOs are granted to employees and at that point do not have any marketable value since they do not trade in the secondary market and are generally non-transferrable. They do, however, have a theoretical value and holders who have a significant amount of options should look to valuation models to create strategies around the theoretical values. The two main valuation models for ESOs are the Black-Scholes model and the Lattice Model (binomial options pricing model). Black-Scholes The Black-Scholes model is a tool for equity options pricing and was originally created for the pricing and hedging of European Call and Put options. The difference in the pricing of European options and American options is that the European options do not take into consideration the possibility of exercising early. American options have the flexibility to exercise at anytime and the classic Black-Scholes model does not take this extra value into consideration in its calculations. There are a few assumptions this model takes into account: The stock pays no dividends Option can only be exercised at expiration Assumes that markets are efficient No commissions are charged Interest rates remain constant Stock returns are normally distributed, thus volatility is constant over time With these assumptions, you can see that the resulting theoretical value would not always be accurate, but are used as a guide for relative comparison. An extension to the original Black-Scholes model was proposed by Merton in 1973 in order to account for annual dividends. This model, however, is not as widely used as the original. The Model C=SN(d 1)-KE (-rt) N(d 2) C = Theoretical call premium S = Current Stock Price t = time until option expiration K = option strike price r = risk free interest rate N = Cumulative standard normal distribution

3 e = exponential term (2.7183) d1 = [ln(s/k) + (r + s 2 /2)t] / s t d 2 = d 1 -s t s = standard deviation of stock returns ln = natural logarithm Black-Scholes estimates the fair value of an option, but must be adjusted for Employee Stock Options. There are three key differences between ESOs and short-term traded options that must be accounted for with the inputs. 1. ESOs cannot be traded which makes them worth less than a traded option that can be sold/exercised at will. 2. ESOs can be forfeited if employee is terminated whereas the Black-Scholes model assumes the option cannot be forfeited prior to expiration. 3. ESOs typically have much longer terms (ten years) than traded options. Lattice Model - Binomial Options Pricing Model The binomial model is an open-form or lattice model that creates a tree of possible future stock-price movements to achieve the option s price. In contrast, the Black-Scholes model is a closed-form model that solves for an option s price from an equation. A big advantage of the binomial is that it can value an American-style option, which can be exercised before the end of its term, and it is the style of option ESOs usually take. Example (Chart 1 - next page) An option is granted on a $10 stock that will expire in one year. We assume there is a 50% chance that the price will jump 12% over the year and a 50% chance that the stock will drop 12% There are three basic calculations. First, we plot the two possible future stock prices. Second, we translate the stock prices into future options values: at the end of the year, this option will be worth either $1.20 or nothing. Third, we discount the future values into a single present value. In this case, the $1.20 discounts to $1.14 because we assume a 5% risk-less rate. After we weight each possible outcome by 50%, the single step binomial says our option is worth $0.57 at grant.

4 A full-fledged binomial extends this one-step model into many steps.

5 Summary There are many factors to take into consideration when deciding how to manage your Employee Stock Options. Utilizing a valuation model to help guide your decisions is a useful tool and she be monitored closely. The Ohana Group at Morgan Stanley specializes in helping their clients create strategies around their ESOs and incorporates those strategies into the client s overall financial plan. References David Harper, ESOs: Using the Black-Scholes Model, Investopedia Black-Scholes Model, OptionTradingpedia.com Kevin Rubash, Bradley University, A Study of Option Pricing Models David Harper, ESOs: Using the Binomial Model, Investopedia Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC ( Morgan Stanley ), its affiliates and Morgan Stanley Financial Advisors do not provide tax or legal advice and are not fiduciaries (under ERISA, the Internal Revenue Code or otherwise) with respect to the services or activities described herein except as otherwise agreed to in writing by Morgan Stanley. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are encouraged to consult their tax and legal advisors (a) before establishing a retirement plan or account, and (b) regarding any potential tax, ERISA and related consequences of any investments made under such plan or account.