Employees’ Subjective Valuation of Their Stock Options: Evidence on the Distribution of Valuations and the Use of Simple Anchors (Summary of Findings)

This research examines employees’ subjective valuations of their stock options, compared to firms’ opportunity cost of issuing those options. In both “real-world” and experiment data, results show that a significant proportion of employees (30%) and experiment participants (47%) apparently fail to fully incorporate the time-value component of option value, and instead anchor on three readily-available option values, two of which lie below cost (zero value, intrinsic value) and one of which lies above (stock price). Further, a stock option education program aimed at mitigating the tendency to disregard the time-value component leads to a significant change in valuations (in terms of both median values and dispersion) and lower reliance on simple anchors. Education that provides a qualitative description of an option-pricing model (i.e., cognitive feedback) has a significant effect on subjective valuations of additional options with differing characteristics, while education that provides quantitative option values (i.e., outcome feedback) has an effect on the valuations of original option holdings.

 The data used in the study was obtained under a confidentiality agreement with Net Worth Strategies, Inc. (NWSI), a national leader in equity compensation planning services, from their employee stock option education programs held at five client sites from September 2004 through March 2006, and was supplemented with an experiment that replicates components of the education program.

The research analyzes the value that employees would forfeit from their current employee stock option holdings if they terminated their employment (Forfeit Value). The study uses two measures:  the difference between an employee’s perception of the Forfeit Value and the corresponding value as calculated using the Black-Scholes formula (Cost); and the extent to which employees use simple anchors (e.g., zero value, intrinsic value) to value their options. Both measures are analyzed before and after completion of a stock option education program.  Highlights of findings from the NWSI data include the following:

  • Before training, the majority of employee stock option recipients in the sample (158 of 210, 75%) estimate the Forfeit Value of their stock option holdings to be less than Cost. The median ratio of perceived Forfeit Value to Cost is 0.40, representing a valuation below cost that is both statistically and economically significant. While these results vary across participating firms, the majority of recipients in each estimate their Forfeit Values to be less than Cost before training.
  • Completing the stock option education program (which explains stock option fundamentals and clearly articulates the value of the recipients’ option holdings) significantly changes recipients’ estimated Forfeit Values. The median change in the ratio of perceived Forfeit Value to Cost is +0.67, a statistically significant change. These results are based on the subsample of recipients who completed an optional post-training survey, and also vary across participating firms.
  • Before training, there is evidence that employees rely on simple anchors to value their options, seemingly ignoring the time value component of option value. Training shifts individuals away from using these simple valuation tools and toward attempting to apply more sophisticated valuation techniques (e.g., Black-Scholes).
  • The before and after training results from the NWSI data are similar to those from an analysis of the subjective valuations of graduate business students who participated in the experiment.

This Summary is based on research publised in a leading accounting academic journal, Contemporary Accounting Research (2011, Volume 28, No. 3, pages 747-793).

Anne M. Farrell
PricewaterhouseCoopers Endowed Assistant Professor Chair of Accountancy
Miami University
Susan D. Krische
Associate Professor of Accounting
American University
Karen L. Sedatole
Associate Professor of Accounting

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