Coke Plan for Option Valuing
Fizzles Out After Few Months

Coca-Cola Co.'s novel plan for valuing its employee stock-option compensation has fizzled out.

The world's biggest soft-drink company made a splash in July by announcing it would begin recognizing stock-option compensation as an expense on its financial statements. The news triggered a brief wave of more than 100 followers among other companies, many reaping a public-relations boost at a time when investors' confidence in corporate accounting practices was falling.

But it wasn't just Coke's decision to expense that piqued market interest. Even more noteworthy was the unique valuation method it planned to use, at Coke director Warren Buffett's urging. Instead of using Wall Street's much maligned, but widely used, Black-Scholes mathematical models, Coke said it would solicit quotations from two independent financial institutions to buy and sell Coke shares under the identical terms of the options to be expensed. Coke then would average the quotations to determine the value of the options.

So much for that plan.

Coke now concedes it won't work and that it will use Black-Scholes after all, notwithstanding the method's drawbacks. Coke made the disclosure in its annual proxy filing this week. The disclosure almost certainly will disappoint investors who favor mandatory expensing of option-based compensation, but had been hoping for a feasible alternative to the subjective results often produced by Black-Scholes models.

It also signals that Black-Scholes, like it or not, may remain the norm even should the Financial Accounting Standards Board follow through with its plans to unveil a proposal this year mandating that public companies treat stock-option compensation as an expense. Currently, expensing such compensation is voluntary, largely because of political pressure that high-tech companies and members of Congress brought on the FASB during the 1990s.

Coke executives Thursday said they had no choice but to abandon the Buffett-backed plan. They said the company eventually concluded that current accounting standards wouldn't allow the new approach and instead require companies to perform their own value calculations.

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In any event, the disclosure in Coke's proxy shows that dealer quotes wouldn't have yielded any different results than a Black-Scholes calculation. Coke says it determined the value of the options through Black-Scholes calculations -- and only then obtained independent market quotes from two dealers "to ensure the best market-based assumptions were used." And, as it turned out, "our Black-Scholes value was not materially different from the independent quotes," Coke's proxy says. Coke declined to name the two financial institutions.

Because the dealer quotes were so similar, "you can assume they use Black-Scholes too," says Gary Fayard, Coke's chief financial officer. Asked if an alternative to Black-Scholes is needed, Mr. Fayard says, "I think it's something that business and the accounting profession need to work on and evaluate."

Given the lack of any meaningful difference, some accounting specialists say future efforts to seek market quotations for employee options likely will be pointless. "All they did was go to the expense of getting quotes from two independent parties who may have used the Black-Scholes model themselves," says Jack Ciesielski, publisher of the Analyst's Accounting Observer newsletter in Baltimore. "The whole affair winds up being an exercise in circularity."

While expensing options remains voluntary, all public companies are required to disclose what the effect on their earnings would be if they did expense options. Most such disclosures rely on variants of the model published in the 1970s by economists Fischer Black and Myron Scholes.

Like almost all valuation models, Black-Scholes hinges on lots of assumptions. For instance, option-pricing models typically require projections of the underlying security's future volatility, as well as the option's expected life. Those aren't easy to project with any precision. Even small changes in assumptions can make crucial differences in results and, consequently, a company's reported expenses. What's more, the Black-Scholes model wasn't designed to value options that, like the kind companies grant to employees, aren't freely transferable.

Coke's proxy shows the difference a few changes in assumptions can make. For purposes of disclosing the value of stock-option compensation granted last year to top executives, Coke says SEC proxy rules required it to assume the options' time horizon would be the full life of the options' terms, or 15 years. That drove Coke to assume relatively lower volatility and interest-rate risk, given the lengthy time horizon. Using those assumptions, Coke calculated that the grant-date value of its options last year was $19.92 a share.

However, accounting rules require Coke to use options' "expected life" when calculating the time horizon used for preparing financial statements. Coke assumed six years. That reduced the options' value, though the effect was partly offset by Coke's assumptions that volatility and interest-rate risk would be higher, given the shorter span. The result: Under that Black-Scholes calculation, the grant-date value was $13.10 a share.

In 4 p.m. New York Stock Exchange composite trading Thursday, Coke shares were unchanged at $37.55.

Write to Jonathan Weil at jonathan.weil@wsj.com³ and Betsy McKay at betsy.mckay@wsj.com⁴

Updated March 7, 2003