Black-Scholes Valuations

Alternatives to Black-Scholes

The Black-Scholes model was developed in 1973 and is widely used today. But there has been additional modeling that has attempted to improve upon it.

Business Week did a study of the following 5 ways to value options:

• Black-Scholes. The Black-Scholes model overvalued options due to vesting and overpaying for underwater options. Plus, the formula is easily manipulated.
• Binomial. The binomial model uses Black-Scholes variables, but assumes options are exercised when optimally profitable. This model can actually produce higher evaluations than Black-Scholes if the company pays dividends.
• Minimum value. This model also uses Black-Scholes factors, but assumes zero volatility. This produced the smallest values using the basic Black-Scholes technique, but the assumption of zero volatility is too fictitious.
• Growth and discount. This method uses the estimated future stock gains to determine option value. This is simpler than Black-Scholes and permits companies that use variable accounting to avoid charges when their stock goes underwater. The problem here is estimating future stock growth — manipulation is too easy.
• Intrinsic method. This method takes you back to simplicity. The stock price minus the exercise price is used as the value. Besides being simple, it’s not susceptible to manipulation, and underwater options have no charge. If stock prices fluctuate wildly (volatility), so will the option values.

Business Week liked the intrinsic method best because it:

"...accurately tracks true options value over time. Uses no ‘assumptions’ that can be tweaked to boost earnings. And it's cheap: With stock gains, other methods would result in much bigger charges and with a depreciating stock, there's no charge at all."