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SUMMARY
Stock options are a major component of executive compensation packages. As such, determining the true earnings of a company requires assessing the true earnings of the employee/executive being offered the stock options and accurately recording the expense associated with them.
Black-Scholes
To calculate the value of employee stock options, many companies rely on the Black-Scholes formula. Here, a differential equation is used to determine how much a call option is worth at any given time.
This method revolutionized the field of financial engineering and earned its developers, Merton and Scholes, a Nobel prize. (Black passed away before the prize was awarded.) By providing a quantitative judgment based upon objective factors, traders now had a way to control risk.
Criticisms of Black-Scholes
While the Black-Scholes method is simple and elegant, its assumptions are restrictive, and it may lead to overestimation of stock values. This is because it was designed to value European, not American options. Also, volatility must be estimated, and dividends are not taken into account.
In the end, an intrinsic method of valuing options may prove the most reliable.