Employees Undervalue Stock Options

March 31, 2004 (PLANSPONSOR.com) - Employees at U.S. companies discount the value of stock option grants by 30% to 50% relative to the options' actual value.

Watson Wyatt, surveying 650 high-income employees who received stock option grants, found a number of different factors that contribute to employees discounting the value of their option grants.   For example, the study notes employees will tend to discount the value of stock option grants because they are risk-averse and less than fully diversified.

Also, the amount employees discount a stock option’s value depends the employee’s company size and performance, as well as the employee’s investment style.   To illustrate this point, Watson Wyatt found employees in smaller organizations who more accurately know their company’s stock price tend to place larger discounts on stock option grants. Yet on the flip side, employees at better-performing companies and workers earning more tend to place smaller discounts on stock option grants.

Interestingly, while more than 80% of employees know their company’s stock price within two dollars, less than a quarter can accurately cite their company’s most recent total returns to shareholders, Watson Wyatt said.

While employees may undervalue stock option grants, they place a much higher value on shares of restricted stock, where the average discount applied by employees is only 18%.   Watson Wyatt points to the greater value employees find in restricted stock, coupled with the U.S. Financial Accounting Standards Board’s (FASB) decision Wednesday to issue an exposure draft outlining the mandatory expensing of stock options as an opportunity to shift stock-based compensation philosophies (See  FASB Hands Down Option Expensing Proposal ).   In fact, Watson Wyatt says employers can potentially reduce their stock-based compensation costs by 20% to 30% by converting their stock option plans to restricted stock grants.

“It will become increasingly hard for companies to justify offering a benefit that costs one dollar while employees value it at only 50 to 70 cents,” Ira Kay, national director of compensation consulting at Watson Wyatt said in a news release. “Employers will need to find more cost-effective ways to compensate and motivate their employees.”

Approximately 646 high income ($50,000+ salary) workers who had received stock option grants from a variety of 300 publicly-traded companies participated in the survey. Copies of the survey report, How Do Employees Value Stock Options, are available by clicking  here .