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1、Trends in FAS 123R Valuation: Market Based & ModelsBest Practices PerspectiveDavid RobertsPresident & CEOEquity Methods2Use a valuation techniqueUse observable market prices for similar assets/liabilities, adjust as appropriateQuoted prices in active markets for identical assets or liabiliti

2、esLevel ILevel IILevel IIIFair Value and the Fair Value HierarchyFair value has been the topic of considerable research, debate, and regulatory attentiona unified framework is rapidly emerging Derived from FAS 157, “Fair Value Measurements3Markets versus ModelsShare-based compensation instruments ar

3、e not tradableWhy observable market prices have historically not existed for employee optionsModels became the de facto standard in measuring the fair value of employee optionsA model estimates fair value by modeling how a market would price the employee option if it could price the employee option

4、(i.e., if it were tradable)4Market-based Valuation: Finally?Search for a market-based valuation methodology is not a new phenomenon, and even traces back to FAS 123R and prior standards, in which it is heralded as the preferred approachIf an observable market price is not available for a share optio

5、n or similar instrument with the same or similar terms and conditions, an entity shall estimate the fair value of that instrument using a valuation technique or model that meets the requirements in paragraph A8 and takes into account (FAS 123R, Paragraph A18)A quoted market price, if one is availabl

6、e, is the best measure of the fair value of an asset, liability, or equity instrument. In its deliberations leading to this Statement, the Board was not able to identify currently available quoted market prices or negotiated prices for employee stock options that would qualify as a price at which a

7、willing buyer and a willing seller would exchange cash for an option. (FAS 123, Paragraph 161)5Market-based Valuation: Chronology of EventsDecember 1994FAS 123 provides fair value framework for valuing employee options, noting a preference for using observable market pricesDecember 2004FAS 123R reaf

8、firms fair value framework and desirability of using quoted prices, while recognizing none are known to exist1995 2004Intense lobbying and debate, with particular focus on the limitations of applying valuation models to employee optionsAugust 2005SEC releases memo describing viable and unviable mark

9、et-based approaches for measuring fair value, in effect rejecting Cisco approach2005Cisco pursues specific market-based valuation approach for measuring fair value2006 - 2007Zions Bancorp develops auction for purchasing derivative securities that track the flows of employee options; SEC notes flaws

10、in approach, but states they are correctable2006 - 2007Google modifies awards its awards to be transferable, thus removing the constraint preventing market-based valuation6Making Decisions: Is Market-based Valuation Right for You?“When we deal in generalitieswe shall never succeed.When we deal in sp

11、ecificswe shall rarely have a failure.-Thomas Monson7Issue 1: Lower ValuationUndoubtedly, a central question companies will ask is how market-based valuations are likely to differ from existing model-based approachesAnswers to these questions must be grounded in thoughtful economic analysisMaking qu

12、ick assumptions as to the potential results of a market-based valuation is a recipe for disaster“Youve got to ask yourself one question: Do I feel lucky?- Clint Eastwood8Market-based values may not always be lower than model-based valuesThis is a firm-specific question companies should investigate b

13、ased upon their own unique circumstancesA more meaningful assessment will examine two general questions:First, is there some requirement in FAS 123R that my company is rigidly required to follow that may deviate from how the market would otherwise process this information in the context of my compan

14、ySecond, is there some difference between how the model-driven fair value developed for my company may differ from how the capital markets would price the same optionAn example of each is providedIssue 1: Lower ValuationExpected volatilityRealized volatilityExpected term periodValuation DateHistoric

15、al period9Expected volatilityRealized volatilityExpected term periodValuation DateHistorical periodExample 1: Term-matching PrincipleFAS 123R states the core volatility objective is to estimate volatility as a market participant wouldWhen using historical volatility, a general approach presented in

16、FAS 123R is the term-matching principle Unfortunately, in some cases this creates tension with the core objective Consider the following example:Measurement Details:Date: Summer 2007Expected term: 6.5 years6.5-year historical volatility: 46%4.5-year historical volatility: 32%Expected volatilityReali

17、zed volatilityExpected term periodValuation DateHistorical period10Example 2: Evolutions in Exercise PatternsWhile both model- and market-based valuations will be historically contingent, markets have more flexibility and resources to formulate reliable expectations as to how/when patterns will emer

18、geA market encompasses a plurality of expectations, and the clearing price represents a “consensus expectationThe manner in which models are utilized under FAS 123R gives precedence to singular expectationsA good example of this concerns exercise patterns, whereby the market will be developing expec

19、tations as to how exercise strategies will evolve as the company also matures and grows11Issue 2: Liability vs Equity TreatmentAssetsLiabilities Balance SheetShare capital & retained earningsMeasured (valued) once at issuanceMeasured (valued) once at issuance, but then remeasured each period the

20、reafterIn their current form, market-based valuation approaches will result in the issuance of securities that create a contingent claim on the assets (cash) or equity of the issuing company, most likely the equityBalance sheet classification as either equity or a long-term liabilityThis classificat

21、ion will have substantial implications on the design of the market instrumentSome considerations:How will this classification decision be made? FAS 150? Future guidance? If classified as liabilities, will periodic remeasurement result in a forced retreat to valuation models?Why is the company issuin

22、g the securities? Are third parties capable of issuing them, instead?Issue may even be resolved by the NASPP date?12Issue 3: Trading VolumeMarkets exist everywhereMarket-based valuation requires a competitive market, which can be measured by factors such as:Number of buyers and sellersNumber of inst

23、ruments demanded relative to the number of instruments offeredTechnology issuesBidders perceptions regarding holding, hedging, and trading costs of instrument13Issue 3: Trading VolumeInsufficient competition will preclude the market-clearing price from being usable for FAS 123R fair value estimation purposesthis would be bad news for is