The goal of this case study is to provide the reader a better understanding of the valuation applications of FAS 123’s preferred methodology (Financial Accounting Standard 123) – the binomial lattice- through a systematic and objective assessment of the methodology and comparing its results with the Black-Scholes model (BSM). This case study shows that, with care, FAS 123 valuation can be implemented accurately. The analysis performed uses a customized binomial lattice that takes into account real –life conditions such as vesting, employee suboptimal exercise behavior, forfeiture rates, and blackouts, as well as changing dividends, risk-free rates, and volatilities over the life of the ESO (employee stock options).
This case study introduces the FAS 123 concept, followed by the different ESO valuation methodologies (closed-form BSM, binomial lattices, and Monte Carlo simulation) and their impacts on valuation. It is shown here that by using the right methodology that still conforms to the FAS 123 requirements, firms can potentially reduce their expenses by millions of dollars a year by avoiding the unnecessary overvaluation of the naïve BSM, using instead a modified and customized binomial lattice model that take into account suboptimal exercise behavior, forfeiture rates, vesting, blackout dates, and changing inputs over time.