Stock Expensing: Calculating Volatility

This article is part of a series meant to help users and auditors better understand the calculations that are being made inside Capshare when calculating a company’s stock expense, either for ASC 718 or ASC 505-50 (previously known as FAS 123R).

Volatility is another important input into the Black-Scholes computation used to generate a company’s option expense for financial reporting purposes.  Volatility is a measure of the company stock’s inclination to either increase or decrease during the life of an option and is often calculated by looking at the volatility of public companies (who’s daily stock prices are available to be analyzed) who are similar to your company.  In Capshare, the user can elect to either calculate volatility using public comparable companies, or to manually input benchmark volatility numbers.

Volatility using Public Comparable Companies:

When preparing an option expense in Capshare, the 4th step in the Wizard asks for volatility inputs, with the preferred method being to input a set of Public Comps (see below):

stock-expensing-calculating-volatility-1

 

By entering public company tickers, the user prepares a list of comps that Capshare will use to calculate the company’s volatility.

Capshare’s Calculation:

Capshare calculates volatility slightly differently for employee vs. non-employee grants.  For employees, the volatility is calculated as of the grant date for each option.  Non-employee grants fall outside of ASC 718 and are technically calculated based on ASC 505-50.  Because of that, there is a mark-to-market component to these grants and the volatility and overall expense are recalculated each reporting period to account for that difference.  So for employees, we calculate the volatility as of the grant date of the option.  For non-employees, the volatility is calculated using the last day included in the option expense report.  The term is then also taken into consideration in both instances to calculate the appropriate volatility.

By default, Capshare rounds the term used for volatility to a whole year.  We found that auditors or users attempting to use the system were frustrated when Capshare would calculate a 6.27 year volatility, which was difficult to replicate without re-calculating the full volatility (Since most common financial databases simply provide full year volatility numbers).  That can be disabled by switching to ‘Custom’ in the drop down under ‘Volatility Term’.

Similarly, Capshare typically caps the volatility term at 5 years.  We’ve found that volatility numbers break down much above 5 years; but again, that can be disabled under ‘Volatility Term’.

Once Capshare has determined the correct date and term, it will pull the appropriate volatility for each comp from Capital IQ.  If Capital IQ doesn’t have the volatility available, Capshare will pull enough daily market data to calculate the volatility itself.  The volatilities for each public comp are then averaged to arrive at the volatility for the grant.

Example:

Let’s look at a grant for John Doe, an employee of the company, with an expected term of 6.27 years and a grant date of 1/1/2010.

  1. Capshare is first going to set the date for the volatility as of 1/1/2010, since John Doe is an employee for the company.
  2. If the default terms are enabled, Capshare will calculate the 5 year volatility for each selected public comparable company.
  3. Once a volatility has been calculated for each company, an average is taken to determine the volatility to be used for John Doe’s grant.

Capshare will then do the same for each other grant in the system.

Volatility using Manual Inputs:

If the user doesn’t want to pull a comp set in Capshare, they can elect instead to enter hard coded 1 year, 2 year, and 5 year volatility numbers for their company.  The most appropriate value (based on each option’s term) would then be applied to each grant and used as the volatility input when calculating the expense.

Volatility tab in the Final Report:

As part of the Stock Expense Report, the volatility tab summarizes the key inputs and information to make it easily available for review:

stock-expensing-calculating-volatility-2

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