When valuing stock options remember the six inputs…and consider going beyond Black-Scholes

BVWireIssue #98-3
November 17, 2010

David Dufendach (Grant Thornton) provided a detailed analysis of “ASC Topic 718 (FAS 123R) -- Valuation of Share-Based Payments” last week at the AICPA National BV conference. Before going into the details that impact stock option valuation, Dufendach reminded the audience of the “six inputs into a model into three buckets”:

  • Contractual features: exercise price, maximum term, and possibly a market condition.
  •  Market features: stock price (if publicly traded), risk-free interest rate.
  • Estimated features: stock price (if closely-held), dividends, volatility, expected term. 

“The third bucket is “is where all the valuation work is…and you can’t make it up,” added Dufendach.  However, sometimes the inputs just don’t fit with Black-Scholes, the most commonly used model in option pricing. “So it’s is a good idea to get outside the world and try the Lattice model, which can accommodate volatility assumptions that change over time; something the B-S-M cannot do.”

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