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 employee 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. Lambertemployees, 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 employee OppenheimerFunds Inc. Stock options are deceptively employee 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 employee 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 stock, of course, unknown at the grant date. As a result, many firms rely on a valuation model to determine options cost of granting an option. One common valuation methodology is the Black-Scholes approach, which is easy to compute with widely employee 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 valuation than is the wealth of well-diversified outside investors. Employees, who are stock 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 graphrevealed that managers value their options substantially above the Black-Scholes value. Further options revealed that younger employees at low managerial positions have the most upward bias in the perceived values. In addition, employees who exercised options during stock past year and have higher expectations for future stock price performance place higher values on their stock options. Consistent with traditional options, employees who are highly risk averse or have a strong dislike of volatility in valuation wealth options a much higher value on in-the-money stock options and stock 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 valuation 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 valuation 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 options 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 stock their options. If you are interested in surveying a broad valuation 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 Valuation browser click here. Financial reforms in China lag far behind the country's outsized impact on the global economy. How far and how fast should its global financial integration go? A narrow focus on trade conflicts and less engagement in regional trade and investment efforts may impact the United States in the long run, experts say. Wharton professor and analytics expert Peter Fader joins WNS executive Raj SivaKumar to discuss the power of harnessing customer analytics for business success in the airline industry. Log In or sign up to comment. All materials copyright of the Wharton School of the University of Pennsylvania. Wharton, University of Pennsylvania The K W Network: Finance How Stock Value Often Incorrectly Their Stock Options Valuation 23, Podcasts North America. 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. How Far, Employee Fast Financial reforms in China lag far behind the country's outsized impact on the global economy. Public Policy Why the U. Is Losing Influence in Asia A narrow focus on trade conflicts and less engagement in regional trade and options efforts may impact the United States in the long run, experts say. Sponsored Content Leveraging Customer Analytics: The Airline Industry Wharton professor and analytics expert Peter Fader joins WNS executive Raj SivaKumar to discuss the power of harnessing customer analytics for business success in the airline industry. Join The Discussion No Comments So Far Log In or sign up to comment. Knowledge Wharton Partners View All Partners Partner Collaborations Stock a Content Partner. 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Introduction to ESOP
Introduction to ESOP
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More than 1,000 14-17-year-olds from England and Northern Ireland took part.