Valuations Using Binomial Option Pricing Model | Groves & Partners

Employee stock options are a common form of compensation in many companies. Employee stock options allow employees to purchase shares of company stock at a predetermined price, typically referred to as the strike price. The idea behind employee stock options is to align the interests of the employees with those of the company's shareholders by incentivising employees to work hard to increase the value of the company's stock. It can also serve as an alternative form of remuneration to cash.

The value of employee stock options can be difficult to determine, particularly when the options have not yet been exercised. One popular method of valuing employee stock options is the Binomial Option Pricing model.

The Binomial Option Pricing Model

The Binomial Option Pricing Model offers a more flexible approach to valuing employee stock options by modelling the possible future price movements of the underlying stock over discrete time intervals. Unlike the Black-Scholes model, which assumes continuous price movements, the Binomial Option Pricing model breaks down the time to expiration into a series of steps, allowing for a more realistic representation of market dynamics.

Key Components of the Binomial Option Pricing Model

• Time Steps:
  The Binomial Option Pricing model divides the option's life into multiple time steps, typically monthly or quarterly, reflecting the passage of time until expiration.
• Price Movements:
  At each time step, the model considers two possible price movements for the underlying stock: upward and downward. The stock's volatility, which measures its price fluctuation over time, determines these movements.
  
• Probability Distribution:
  The model calculates the probabilities of these price movements based on the volatility and the risk-neutral probability of an up or down movement.
• Option Valuation:
  The model arrives at the option's fair value by recursively calculating the expected option value at each step, starting from expiration and working backward to the present.

Advantages of the Binomial Option Pricing Model for Employee Stock Option Valuations:

• Flexibility:
  The Binomial Option Pricing model can accommodate various factors such as dividends, early exercise, and changes in volatility, making it well-suited for valuing employee stock options with non-standard features.
• Accuracy:
  By incorporating discrete time steps and multiple possible price movements, the Binomial Option Pricing model provides a more accurate estimate of employee stock option value, especially in dynamic market conditions.
• Customisation:
  Employers can tailor the model to account for company-specific factors and market conditions, resulting in more precise valuations that reflect the organisation's unique circumstances.

Importance of Accurate Valuation of Employee Stock Options

Accurate valuation of employee stock options is important for several reasons. First, it helps companies determine the appropriate amount of compensation to offer employees. If the value of the options is overestimated, the company may be offering employees more compensation than is warranted. Conversely, if the value of the options is underestimated, the company may be underpaying employees.

Accurate valuation of employee stock options is also important for financial reporting purposes. Companies must report the value of their employee stock options as an expense on their financial statements. If the value of the options is inaccurate, the company's financial statements may be misleading, which can have serious consequences for investors and other stakeholders.

Finally, accurate valuation of employee stock options is important for tax purposes. Tax advisors should be consulted to understand better the tax implications of issuing employee stock options.

Find Out More

Employee stock options can be valuable for companies to attract and retain talented employees. However, accurately valuing employee stock options can be challenging, particularly when the options have not yet been exercised.

Groves & Partners has expertise in valuing employee stock options. To find out more, contact us on 1300 892 717 (+61 2 7208 7970) or via email at info@groves.com.au.