Stock options are rights to purchase a firm’s stock at a specific price at some designated period in the future. Although stock options are sometimes sold directly to investors, they are usually granted as part of the compensation paid to key executives and other employees. Stock options, as a means of compensation, offer several distinct benefits to firms and employees. Because the value of stock options depends on the future market price of the firm’s stock, option holders are highly motivated to improve the performance of the firm. Actions that benefit the firm’s stockholders also directly benefit the option holders. As a result, managers and other employees who hold stock options have the same objective as company shareholders: to make the firm’s equity securities more valuable. In addition, although option holders gain if the price of the optioned stock subsequently rises, they avoid the “downside risk”of loss if the stock price declines. If the stock price is below the option price, the option simply will not be exercised.
A more arguable advantage of stock options from the firm’s point of view is the manner in which options are currently handled in financial statements. Current accounting rules allow firms to choose between two different ways of reporting the cost of employee stock options, based either on intrinsic values or fair values of the options at the date of grant. The intrinsic value method measures the compensation cost of stock options as the excess of the stock’s market price over the option price at the date of the grant. Because most employee options are granted at or above market value, firms that elect this method do not recognize any compensation expense associated with the options. Under the alternative fair value method, compensation expense is measured at the grant date based on the estimated fair market value of the award. Fair values of options must be estimated based on a theoretical model and various assumptions. Estimated stock option values and related compensation expenses can vary significantly, depending on the assumptions used and the model selected.