Stock Expensing: Calculating the Fair Value of an Option

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).

Fair Value:

At the core of the ASC 718 expense, is a calculation of an option’s fair value per share.  Capshare uses the Black-Scholes formula to determine an option’s fair value per share.  The Black-Scholes formula is a common calculation, and plenty of other articles have been written around it’s specifics.  For our purposes, there are five inputs that are needed to run a Black-Scholes calculation:

Once all of those are calculated, the Black-Scholes formula will return an estimate of the value of the option.

Before we can determine the appropriate numbers to use for each of these five inputs, we must first determine the appropriate calculation date to use for the grant.

ASC 718:

ASC 718 specifies that employee stock options should be valued as of their grant date, and that the value should then be expensed over the useful life of the grant.  So for each employee grant, the calculation of value should be done as of that grant’s grant date.

ASC 505-50:

Under ASC 505-50, non-employee grants should be re-valued during each reporting period, rather than using the original grant date.  Capshare does this by calculating the value of the grant as of the last day of the reporting period for the expense that’s being performed.

Once the appropriate date is determined, each of the five inputs is calculated.  Below, we’ve included a summary of how Capshare determines the value for each input:

Underlying Value of Common:

When preparing a stock expense, Capshare will ask the user to input the date and value of common for any historical 409A reports prepared on the company’s behalf.  If a 409A wasn’t prepared, an estimate of the value of common at that time should be entered (likely one that correlates with the strike price that was being used for options at that time).  Capshare will use information from this table to set the appropriate underlying value of each grant as of its calculation date.

Exercise Price of the Option:

The exercise price is pulled directly from the information entered by the user for each option.

The Option’s Term:

For options that fall under ASC 718, we use the SAB 107 method for calculating an estimated term for each option.  For ASC 505-50 grants, we take the remaining contractual term for each option.  Click here for a more detailed explanation of how Term is calculated in Capshare.

Risk Free Rate:

A risk free rate is pulled directly from Capital IQ using US Treasury Rates.  Again, the risk free rate correlates with the pre-determined Calculation Date, and the term calculated above.

Volatility:

Capshare allows users to pull a set of public comparable companies from which it will calculate an appropriate volatility for each grant.  Click here for a more detailed explanation of those volatility calculations.

Once Capshare has the information it needs, a Black-Scholes calculation is performed on each grant to determine the appropriate Fair Value.  That information is summarized and available for review in the ‘Fair Value Calculation’ tab of the generated report: