When valuing stock options for purposes of Accounting Standards Codification 718 – Stock Compensation (“ASC 718”) various valuation methods can be applied. Some of the more common methods include the Black-Scholes formula, a lattice model, and a Monte Carlo simulation.

This article assumes use of the Black-Scholes formula (a closed-form model); as this is the method most private companies’ use.[2] We will explain where the typical inputs for each of these six factors are found and in certain cases, how they can be modified to fit the facts and circumstances of a specific situation.

Regardless of which method is applied, the standard stipulates that reasonable and supportable estimates must be documented for the following six factors:

The Exercise Price of the Option
The Expected Term of the Option
The Current Price of the Underlying Share
The Expected Volatility of the Price of the Underlying Share for the Expected Term of the Option.
The Expected Dividends on the Underlying Share for the Expected Term of the Option.
The Risk-free Interest Rate for the Expected Term of the Option.

Final Thoughts

When the Black-Scholes method is used to value options, ASC 718 requires that each of the six inputs be reasonable and supportable.  To fulfill this requirement, it is important that the selected inputs are consistent with the facts and circumstances of the company, the option agreements, and market information (when available).

[1] ASC 718-10-55-21.

[2] There are many circumstances where a lattice model or Monte Carlo simulation would be a more appropriate method for valuing share based payments.  These are not discussed in this article.

[3] ASC 718-10-55-30.

[4] ASC 718-10-55-28 and 718-10-55-37.

[5] Treasury yields can be found at: http://www.federalreserve.gov/releases/h15/