Reading financial statements: options

When reading financial statements, it is worth checking to see if stock-based compensation is being expensed properly.  Here’s how.

Usually they will use the Black-Scholes model to value options and they will state the expected volatility figure.  Compare that number with the historical volatility of the stock.  One easy way to get historical volatility information is to look at the Morningstar Options website (here is the page for Berkshire Hathaway).

I’ve highlighted historical volatility data in the picture above.

Another thing to check is option valuation as implied by market prices, shown below.

EDIT (3/7/2015): The Morningstar website no longer has these options.  Yahoo Finance will show implied volatility.

If there is a big discrepancy between the three (volatility according to the financial statements, historical data, and market implied values) then it is possible that something fishy is occurring.  Changing the assumptions behind expected volatility is a method of adjusting GAAP earnings.

From what I have seen so far, it is rare for companies to do this.  The only egregious case I have seen is Evertz’s IPO prospectus (filed on SEDAR).

The stock-based compensation that has been charged against income is $115 for the year ended April 30, 2006 (2005 — $12; 2004 — $0;
2003 — $0; 2002 — $0). Compensation cost was calculated using the Black-Scholes option pricing model with the following assumptions: risk
free interest rate 3.75% (4.0% in 2005); dividend yield of nil; expected volatility of 0% and expected life of 5 years. The weighted average fair
value of each option granted during the year ended April 30, 2006 is $0.42 ($0.54 in 2005).

The assumption of future volatility being 0% is extreme.  This is the same as saying that the IPO will never be re-priced (it was) and that Evertz’ stock price will not fluctuate (but of course stock prices fluctuate).  0% is way too low.  The options granted were worth several million dollars upon Evertz’ IPO yet they were only expensed at $115k.  When reading financial statements, sometimes the devil is in the details.

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