Home' A Plus Magazine : Nov 2012 Contents Alex Leung is senior director of business and financial
instruments and Ross Wang is manager of business and
financial instruments in the valuation and advisory services
unit of CBRE.
November 2012 47
share value Expected
Increase in parameter
Table 1 - Relationship between value of parameters and value of share options
Table 2 - Expense amortization table
expected volatility, expected dividend yield
and risk-free interest rate) have to be taken
into consideration (see Table 1).
Expected life of the option: The expected
life of an option is largely determined by its
remaining contractual life to maturity: the
longer the remaining contractual life, the more
chance that the intrinsic value of the option
will increase and, thus, the more valuable
the option. Nevertheless, the expected life
of an option is also influenced by a number
of factors such as the length of the vesting
period, past exercise history, the employee's
position within the organization and expected
volatility of the underlying shares.
Current share value: If the underlying
company is listed in an active market, the
public quoted price is the price indicator of
the current share value. In general practice,
the closing price of the underlying shares as
at valuation date is adopted as the current
share value. For an unlisted company,
however, a separate valuation on the
underlying company is required. Typically,
a full-scale business valuation on the equity
interest of the company has to be performed
before the valuation specialist determines
other option pricing model inputs. Such a
situation is common for the valuation of pre-
IPO share options.
Expected volatility: Share price volatility
measures the level of share price fluctuation
during a given period. As much of the value
of a share option is sourced from its potential
for appreciation, share price volatility has a
significant impact on the estimation of the
share option's fair value. Expected share
price volatility can usually be determined
with reference to the historical volatility of the
underlying share price over the same as the
expected life of the option. In addition, the
time range adopted for the historical volatility
must be consistent with the expected
option life. If long-term historical volatility
is adopted, valuation specialists must make
appropriate adjustment to price observations
for normalization to avoid any outlier effect.
Expected dividend yield: If the holder of
a share option is not entitled to a dividend
on the underlying shares, the expected
dividend will have a negative impact on
the value of the option. Other things being
equal, the higher the dividend yield, the less
valuable the option. This parameter usually
can be determined with reference to the
firm's prevailing dividend policy, dividend
payout history, industry peers' practice or
management's reasonable estimation.
Risk-free interest rate: The risk-free interest
rate affects the price of an option in a less
intuitive way than expected volatility or
expected dividends. IFRS 2 specifically states
that the risk-free interest rate should be the
implied yield available at the date of grant on
zero-coupon government issues. However, it
may also be necessary to use an appropriate
substitute in some special circumstances, if
there are no comparable government issues
or the overall economy has high inflation.
Expensing the employee stock option
Under IFRS 2, for an employee stock option
without any vesting conditions, the expense
shall be recognized at the grant date. If a
vesting condition is attached to the employee
stock option, the expense shall be spread
over the relevant vesting period.
It is worth mentioning that for employee
stock options that mature over several
financial reporting periods, a valuation is
required only at the grant date. Subsequent
corrections to the annual expense figure
may normally be caused by a change in the
number of options, but not by a change in
the fair value of the options.
Example: A company granted an
employee stock option scheme to its
employees on 30 June 2012. Four tranches
of employee stock options with different
vesting periods were granted. The assessed
fair value of each tranche was $10,000 as
at the grant date. The financial year of the
company is from 1 January to 31 December.
The expense of the employee stock option
could be allocated in the way as shown in
Table 2 (see above).
Traditionally, share options are represented
by standard European and American options.
Nevertheless, along with the development
of financial markets, a series of new options,
such as Bermudan options, Asian options,
barrier options and other exotic products
have become more common.
The growing complexity of share options
calls for more advanced valuation models
and techniques. Besides the Black-Scholes-
Merton and binomial tree models, valuation
specialists have also adopted the trinomial
tree model, finite difference method and
Monte Carlo simulation method to tackle
heavily structured share options.
As issuing employee stock options could
result in significant profit and loss impact,
companies are advised to assess the fair
value of options at an early stage.
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