A Simple Formula to Calculate the Cost of Executive Stock Options

Abstract:     
We derive a simple formula for the cost of the ESO to the firm at the grant date under the assumption that the executive has a constant market-to-strike multiple. The market-to-strike multiple is defined as the ratio of the market price on exercise to the strike price of the ESO. The expected value of this multiple is the only input that needs to be estimated for calculating ESO cost using our formula (hence-forth, KLS formula). Using a large data set of insider trades, we find that the KLS formula has a lower prediction error relative to the Black-Scholes-Merton (BSM) formula. We also find that the error due to the assumption of a constant market-to-strike multiple is quite small. Further, our model generally leads to negative prediction errors whereas the BSM model generally has positive prediction errors. A composite estimate of ESO costs using the average of both methods (KLS and BSM) proves much better than either method individually.

Number of Pages in PDF File: 35

Keywords: Executive Stock Options, Executive Compensation, Accounting Cost

JEL Classification: C61, G13, G30, J33, M12, M41, M52

working papers series