SFAS 123(R) Valuation Issues in
Today’s Environment

The unusually high volatility in the financial markets in late 2008 and early 2009 has created a need to reassess the assumptions used to estimate the fair value of stock compensation under Statement of Financial Accounting Standards No. 123(R), Share Based Payment (SFAS 123(R)).

Company values and assumptions of expected volatility have been particularly impacted. Many companies will want to reconsider the appropriateness of their historical assumptions in today’s environment. We have summarized the key issues below.

Overview

Stock option valuations use option pricing models such as Black-Scholes and lattice models, which require inputs for exercise price, fair value of the underlying stock, expected volatility, expected dividend yield, risk-free interest rate, and expected term. Exercise price is established by the terms of the stock option award. In contrast, judgment is required in developing the remaining five inputs. Considerations related to developing these inputs in light of recent market conditions are briefly discussed below.

Fair Value of the Underlying Stock

For public companies, this input is evident—it is the publicly traded price of the company’s stock. Private companies, on the other hand, must rely on the appraised fair value of their common stock. This value is often derived from the most recent appraisal obtained by the company to satisfy the requirements of the Internal Revenue Code Sec. 409A. The appraisal of private common stock involves two parts: (i) the valuation of the equity or invested capital of the company, derived from methods such as discounted cash flows, public company multiples, transactions, or implied values from recent rounds of financing; and (ii) the valuation of the common stock, which considers the rights, preferences, and liquidity of the company’s various classes of stock, often using option pricing models. The valuation of private company common stock requires material judgment, and must withstand scrutiny from parties such as the SEC, IRS, and audit firms.

Given the market turmoil over the last several months, both company values and the value of common stock have generally experienced substantial declines. Company values have been affected by a number of factors including reduced earnings expectations, the increased cost of capital, lower comparable company stock prices, and distressed transactions. The value of common stock, apart from the obvious affect of the reduced company values, has suffered because of a general increase in liquidity discounts caused by longer expected terms to liquidity and increased company volatilities.

Volatility

The assumption of expected volatility is based on consideration of both historical and implied volatilities witnessed in the marketplace (for the subject company if public, or for comparable public companies if private), weighted in some fashion. Both have been impacted by recent market conditions but to differing degrees. Although volatilities have risen substantially over the last several months, the increase will only have a limited impact due to overall historical volatility being based on a longer period consistent with the expected term assumption, typically several years. Implied volatilities, which reflect the volatility assumption implied in current prices of publicly traded options (typically one to two years in term), have increased significantly. In cases where trading volume for options is low and bid-ask spreads are wide, it may be more appropriate to consider alternate methods for calculating implied volatility, such as using shorter-term, more liquid options or analyzing volatility data for time periods prior to your valuation date. Since SFAS 123(R) emphasizes consistency of methodologies, however, we recommend you discuss available methods with your auditors before making any changes to your volatility assumptions, including changes related to the weighting of implied and historical volatilities.

Expected Dividend Yield and Risk-Free Interest Rate

For many dividend-paying companies recent declines in stock prices have brought substantial increases in dividend yields (calculated as current dividends divided by current stock prices). In estimating the dividend yield assumption appropriate for use in an option model, an assessment should be made as to whether using current yields is appropriate. It may be more appropriate to use longer-term average dividend yields, prior to the recent market turmoil, to better reflect future dividend expectations. In addition, recent U.S. Treasury yields, used as a proxy for the risk-free rate, are at abnormally low levels.

Expected Term

Expected term is usually impacted by market conditions less than volatility and dividend yields. With significant declines in stock prices and increased volatility in the market, many options that were previously in-the-money may now be out-of-the-money, leading to potentially altered exercise patterns. In this market, it may be appropriate to analyze historical option exercise history over a longer period of time when making a determination of expected term. Given the current market environment, it may be prudent to contact your advisors before developing any current SFAS 123(R) assumptions.