One of the more intriguing changes in executive and employee compensation is the increase in the use of stock options. The typical explanation for the use of stock options is that these compensation vehicles enable companies to attract and retain the best employees and also provide superior incentives for employees to increase shareholder value.
While these explanations seem reasonable on the surface, they hinge on the assumption that employees understand how stock options work. Yet according to recent research by Wharton professors David F. Larcker and Richard A. Lambert , employees, in fact, tend not to understand the basic economics of stock options — a finding that has important implications for employees, employers, boards of directors and management consultants.
An earlier survey, this one conducted in May by OppenheimerFunds Inc. Stock options are deceptively simple compensation contracts. When an option is exercised, its payoff rises by one dollar for each dollar the stock price is above the exercise or strike price. If the stock price is below the exercise price when the option matures, the option is left unexercised and its payoff is zero.
What stock prices will be five to ten years in the future are, of course, unknown at the grant date. As a result, many firms rely on a valuation model to determine the cost of granting an option. One common valuation methodology is the Black-Scholes approach, which is easy to compute with widely available programs and provides a reasonable indication of the expected cost to the firm of granting a stock option.
Although the cost to the firm can be reasonably estimated, the value of the stock option to an employee is not simply the Black-Scholes value. This is because the wealth of employees is much more highly tied to the value of the firm than is the wealth of well-diversified outside investors. Employees, who are contractually forbidden from selling their options to outside investors, therefore have less ability to hedge the risk associated with holding options, and they are more likely to exercise options early for both liquidity and risk reduction reasons.
Thus, the value of a stock option to an employee should not exceed the Black-Scholes value of the option. Black-Scholes and other similar models provide theoretical figures for the cost of the option to the firm or the upper bound to the value of the option to the employee.
However, almost nothing is known about how employees actually value their stock options. It was also one of the questions asked by the Larcker and Lambert survey, conducted with iQuantic Inc. The survey participants were managers or top-level executives from 98 different firms. The typical respondent had been granted options three times by his current firm and had exercised options once.
So, despite poor recent stock price performance and high volatility, the respondents appeared very optimistic about the future. The results, shown in a graph , revealed that managers value their options substantially above the Black-Scholes value. Further analysis revealed that younger employees at low managerial positions have the most upward bias in the perceived values. In addition, employees who exercised options during the past year and have higher expectations for future stock price performance place higher values on their stock options.
Consistent with traditional economics, employees who are highly risk averse or have a strong dislike of volatility in their wealth place a much higher value on in-the-money stock options and a much lower value on out-of-the-money stock options.
Finally, says Larcker, there is some preliminary evidence that men do a slightly better job valuing stock options than women. In several instances multiple employees from the same firm responded to the survey. The results for a firm engaged in software development and consulting are presented as are the results for a firm engaged in computer hardware manufacturing. With some exceptions, the respondents valued their options above the upper bound computed from Black-Scholes.
Moreover, these figures revealed that employees generally do understand how the value of a stock option decreases as the option falls further out of the money. The figures also demonstrated that there is substantial variation in the perceived value within managers of the same company.
It is difficult to believe that stock options have the desired effect on employee behavior if employees do not understand the basic economics of stock options. Clearly employers need to develop more sophisticated training programs, the researchers suggest.
For example, firms need to educate employees about the expected range of value for stock options and perhaps point out that the expected value is probably less than the Black-Scholes estimate. Moreover, the training program needs to be tailored to the bias associated with specific employee characteristics. For example, younger employees in technical areas may have a different set of problems understanding stock options than senior-level managers in marketing.
How many options would satisfy the employee: The goal of this research is to understand how employees value stock options and to identify the factors that cause employees to over-value or under-value their options. If you are interested in surveying a broad cross-section of your employees about how they value their options, please contact David Larcker larcker wharton.
To see a sample report from this survey best viewed using the Internet Explorer browser click here. Many employers purposely set low default rates for employee retirement savings -- but their worries about increasing them are largely unfounded, Wharton research shows.
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A Primer on Stock Options Stock options are deceptively simple compensation contracts. Implications for Firms It is difficult to believe that stock options have the desired effect on employee behavior if employees do not understand the basic economics of stock options.
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