6. Why the Option Pricing Method trumps the Current Value Method

Understanding Methods of Allocation.

The Option Pricing Method has complicated the lives of valuation analysts industry-wide.

The Current Value (CV) method has been employed in stock option calculations for many years, both by investors and valuation practitioners. For many years it has been considered the tried-and-true method of value allocation. Sadly, this is no longer the case.

To level-set, the CV method takes the equity value of an entity, subtracts preferences and divides the result by the number of fully diluted shares outstanding to come up with a per share value of stock. Simple enough. But the Financial Accounting Standards Board was unimpressed with the CV method. What they didn’t like was the fact that the CV calculation results in a negative value if preferences outweigh equity value. (In the world of finance, an option by definition has a positive value.) Thus came the irreverent exclamation from the FASB, “well, if all those options are worth zero (or less), then give them all to us.” Touche.

So by fiat the FASB and its practitioners caused the replacement of CV system-wide, at least as it pertains to stock option valuation. The new standard became known as Fair Value. Fair Value, for purposes of valuing common stock, now relies on two alternative methods: 1] the Probability Weighted Expected Return Method (PWERM), and 2] the Option Pricing Method (OPM). While each has its place, the OPM is favored by practitioners because, frankly, it is simpler to audit.

Naturally, the OPM uses the Black-Scholes model to distribute the equity value across the capital structure -- in other words, to calculate the value of a common stock option. Mechanically speaking, this requires the valuation analyst to input share price, volatility, and several other variables to calculate the time-based value of the option. (Note that share price and volatility are highly sensitive inputs.) What happens when using the OPM is that the securities on the outer reaches of the capital structure take more value than the CV method might suggest.

Now that Fair Value has taken hold, it is being enforced with teeth by the Big Four. What’s more, the IRS is apparently “leveraging the work of the Big Four” as they contemplate 409A compliance, according to at least one high-ranking IRS engineer. In other words, CV has been kicked to the curb.

Unfortunately, since the FASB discredited the CV method, we can no longer use it to backstop the value of the stock option found under OPM. In the end, stock options under OPM have more value (sometimes significantly more value) than under CV, and there's not a whole lot we can do about that, whether or not you believe it fits the "reasonable man" standard.

In summary, there is a lot that goes into a stock option valuation report. It actually gets more complicated from here, including not only the mechanics of the OPM but also the Reverse OPM. But let’s leave that for another day.