Managers tend to overvalue stock options vs. restricted stock

While stock options became a celebrated form of dot-com compensation during the ’90s high-tech boom, most people today assume they are an equity incentive offered only to senior executives.

Yet in 2002, more than 90 percent of the stock options granted at S&P 500 companies were awarded to non-executive level employees. Recently, some of these firms have switched from awarding mid-level employees stock options—an option to buy a firm’s stock for a fixed price during a future time period—to awarding them restricted stock—stock granted to an employee that cannot be sold until the employee satisfies a vesting requirement.

But do those employees know how to value equity compensation accurately? Many do not, according to a study by Frank Hodge, Shiva Rajgopal and Terry Shevlin, professors of accounting at the University of Washington Foster School of Business.

Hodge, Rajgopal and Shevlin found that managers, on average, overvalue stock options relative to their theoretical fair value. Theoretical fair value is computed using the Black-Scholes option pricing model, which takes into account a firm’s current stock price, the option’s exercise price, the risk-free interest rate, the option’s time to expiration and the firm’s stock price volatility.

No lottery ticket
The study analyzed survey data from 192 current and future mid-level managers enrolled as executive and day-time MBA students at the Foster School. On average the managers had eight-plus years of work experience in a variety of industries; 43 percent had been granted stock options and 16 percent restricted stock.

In the survey, the average manager:

• assigned a value 29 percent greater than the option’s theoretical value,
• overvalued stock options relative to an equivalent fair value package of restricted stock,
• valued quick vesting and extended expiration dates when valuing options,
• tended to extrapolate recently rising stock prices when valuing both options and restricted stock, and
• often treats stock options like a “lottery ticket.”

“Not surprisingly,” Hodge explains, “managers who report having a lower self-understanding of how options work are more likely to treat options in this manner.”

Get financially educated
Hodge says that employees usually learn to value options or restricted stock from peers. But such word-of-mouth education tends to spread, at best, information that only proves useful under certain market conditions. And misinformation can be costly. For example, a 2003 survey by Fidelity Workplace Services found that nearly half a million US households let valuable options expire from 1999 to 2000.

Firms that switch from broad-based option plans to broad-based restricted stock plans should pay special attention to educating employees on valuation, Hodge adds, lest they create unintended, negative reactions from employees who do not recognize a “fair” trade.

“Our study emphasizes the importance of educating employees about how to value stock options, something few firms do in any detail,” he says. “Many firms are hesitant to do so because it requires a discussion of potential future stock prices, a legally sticky issue.

“But failure to understand how to value stock options and restricted stock can lead employees to make poor financial decisions.”

Frank Hodge is the Herbert O. Whitten Professor of Accounting, Shiva Rajgopal is the Julius A. Roller Professor of Accounting, and Terry Shevlin is the Paul Pigott-PACCAR Professor of Business Administration at the Foster School of Business. Their paper, “Do managers value stock options and restricted stock consistent with economic theory?” is published in the fall 2009 issue of Contemporary Accounting Research.