Stock Option Valuation for Thinly Traded Enterprises: Comparing the Historically Based Intrinsic Value Model to the Black-Scholes-Merton Model

Abstract

A publicly traded company’s reporting is often affected by the valuation of stock options. For large, regularly traded companies, the valuation of stock options isn’t an issue because these companies have valuation data for publicly traded options. For thinly traded, highly volatile companies, the issue of establishing a fair value can seriously impact thinly traded, highly volatile companies’ bottom line. Generally Accepted Accounting Principles or GAAP as promulgated by accounting standard setters such as the Financial Accounting Standards Board (FASB) or the International Accounting Standards Board (IASB) require that stock options issued by companies must be valued at their fair value. In order to value these options, most accountants use the Black-Scholes-Merton (BSM) option pricing model because of its simplicity. While evidence suggests that the model is effective for larger entities with regularly traded stocks, the BSM model becomes less effective when a stock’s price is highly volatile or trading is less regular. The Historically Based Intrinsic Value (HBIV) model is a proposed alternative model that makes similar assumptions to the BSM model. In this thesis, the author will test the two models on theoretical call options for 59 highly volatile, thinly traded stocks to establish whether or not the HBIV model is a valid alternative to the BSM model, which could improve the accuracy of financial reporting for thinly traded, highly volatile companies.