FAS 123(R) Option Assumptions: The 2007 Results

Watson Wyatt recently completed its second annual analysis of stock option valuation assumptions and results under Statement of Financial Accounting Standards (SFAS) 123(R).¹ From 2006 to 2007, the percentage of companies disclosing option fair values decreased from 74 percent to 73 percent, and the number disclosing stock compensation expense increased from 93 percent to 94 percent. Median stock compensation expense increased by 9 percent in 2007.

The analysis looks at stock volatility, expected option life, assumed dividend yield, risk-free rate valuation assumptions and other data, as well as the strike price and fair market value (FMV) per option for new grants first reported in the 2007 10-K filings of 909 companies in the Fortune 1000 as of November 2008.²

This is the first year Watson Wyatt compiled the total FMV of new grants. Figure 1 shows the median percentage increases in total stock compensation (options and restricted shares combined) and total FMV of new option grants by economic sector. The median total FMV of options granted in 2007 declined by 1 percent. This is a much smaller decrease than we saw in 2006 and 2005, when the median declines were 10 percent and 6 percent, respectively.

Figure 1
Percentage increase in stock compensation and FMV of new option grants

Source: Watson Wyatt Worldwide.

We also compiled total stock compensation expense (options and restricted shares combined) for the first time. Median stock compensation expense increased by 9 percent in 2007. The median percentage increases in 2006 and 2005 were significantly greater due to the transition to FAS 123(R) accounting: 92 percent in 2006 and 35 percent in 2005.

The median total FMV of new option grants declined from 2.4 percent of selling, general and administrative (SG&A) in 2006 to 1.8 percent in 2007. Figure 2 presents both the median FMV of new option grants and total stock compensation expense expressed as a percentage of SG&A for 2007 and 2006. Median stock compensation expense declined from 2.8 percent of SG&A in 2006 to 2.3 percent in 2007.

Figure 2
Median FMV of new option grants and stock compensation expense as a percentage of SG&A for 2007 and 2006

Source: Watson Wyatt Worldwide.

The 2007 median assumptions for all collected data items are shown by economic sector in Figure 3.

Figure 3
Median assumptions for 2007 disclosures by economic sector

Source: Watson Wyatt Worldwide.

The median fair value expressed as a percentage of strike price fell by 1.2 percentage points from 2006 to 2007 (it had decreased by 0.2 percentage points from 2005 to 2006). Figure 4 shows the median changes from 2005 to 2006 and from 2006 to 2007 by major economic sector. The changes in volatility and fair value as a percentage of the strike price are percentage-point changes.

Figure 4
Median changes from 2005 to 2006 and 2006 to 2007 by economic sector

Source: Watson Wyatt Worldwide.

The distributions of the percentage-point change in fair value measured as a percentage of strike price are shown in Figure 5.

Figure 5
Change in fair value as a percentage of strike of new grants

Source: Watson Wyatt Worldwide.

The assumption that typically has the largest impact on option fair value is stock volatility — a larger stock volatility assumption produces a larger option fair value. The median volatility assumption decreased from 30 percent in 2006 to 29 percent in 2007 (see Figures 6 and 7). The changes were minimal for most companies — 8 percent had no change in 2007.

Figure 6
Volatility assumption

Source: Watson Wyatt Worldwide.

Figure 7
Change in volatility assumption

Source: Watson Wyatt Worldwide.

The next most important assumption is typically expected option life. A longer expected option life generates a larger option fair value. The expected option life assumption tends to vary with certain contract or plan provisions, such as the vesting period and contractual term.

The distribution of expected option life assumptions has consistently centered on the range of five years (Figure 8). Of companies that changed their expected option life assumption, roughly half increased and the other half decreased their expected assumptions, consistent with prior years (Figure 9). In 2007, 37 percent of companies did not change their expected option life assumption, compared with 31 percent in 2006 and 44 percent in 2005.

Figure 8
Expected life assumption

Source: Watson Wyatt Worldwide.

Figure 9
Change in expected life assumption

Source: Watson Wyatt Worldwide.

The average dividend yield assumption has remained roughly the same in 2005, 2006 and 2007 (Figures 10 and 11). A larger dividend yield assumption produces a smaller option fair value.

Figure 10
Dividend assumption

Source: Watson Wyatt Worldwide.

Figure 11
Change in dividend assumption

Source: Watson Wyatt Worldwide.

The risk-free rate assumptions remained relatively unchanged from 2006 to 2007 (Figures 12 and 13). A larger risk-free rate assumption produces a larger option fair value. Risk-free rate assumptions should not vary much between options granted on the same date because such rates are typically tied to an external benchmark rate.

Figure 12
Risk-free rate assumption

Source: Watson Wyatt Worldwide.

Figure 13
Change in risk-free rate assumption

Source: Watson Wyatt Worldwide.

Conclusion
In last year’s survey, 15 percent of the companies granting new options used a binomial lattice to determine the fair value. In “Valuing Stock Options: Is It Time to Reconsider Binomial Lattice Models?” we explore the impact that transitioning to international accounting could have on the selection of a valuation method. After discussing the advantages and disadvantages of Black-Scholes and binomial lattice, we advise companies to reassess their valuation methods, particularly when they transition to international accounting.

¹ Our previous analysis appeared in “The Results Are In: FAS 123 Option Assumptions,” Watson Wyatt Insider, November 2007.
² The analysis uses Watson Wyatt’s database compiled from the 2004, 2005, 2006 and now 2007 10-K filings of Fortune 1000 companies.