OT-abh3vt. The new stock option reporting rules are complex due to the multitude of variables involved. There are two primary aspects to the option accounting rules.
1)Determing the fair value of the options on the date of grant.
2)Determing the period over which the option fair value on the date of grant should be expensed.
Determining the fair value involves the following variables: exercise price of the option, expected term of the option, current underlying share price, expected volatility of the price, risk free interest rate and expected dividends.
The period of expensing is based on the vesting period. For example employee A is grated an option to purchase 5000 shares at a strike price of $10. The options have a 10 year term, but they vest(become exerciseable) after 3 years of employment.
In this case the 10 year term and the stike price of $10 would be used in determing the fair value on the grant date. Lets assume that the option grant has a fair value estimate of $3000 on the date of the grant.
In this case, the Company would recognize $1000 of option expense over the next 3 years.
As to out of the money or in the money those are just variables that are used in the calculation of fair value on the grant date. One way to look at it is the value of leaps traded in the open market. In the money and out of the money options have a value as demonstrated by the value of leaps traded in the open market.
As to including expensing of options in valuing a stock. This is a tough question. Currently I do adjust my valuations after the expense because I believe the average investor will use the net eps in their valuation equation for buying and selling stocks.
Logically, however, I believe it should be excluded. Assuming an employee exersizes the options and sells them in the open market, the company will never actually incur the expense. I think adusting the fully diluted share count is a more accurate depiction of the effect on the company.
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