Because observable market prices are generally not available for employee stock options, companies will need to use an option-pricing (or equity valuation) model to estimate the fair value of employee stock options and other employee equity awards, such as restricted stock with market conditions. The best known valuation techniques are the Black-Scholes-Merton (Black-Scholes) model, Monte Carlo simulation models, and lattice (or binomial) models.

This chapter discusses the considerations involved in selecting an option-pricing or equity valuation model, the theoretical underpinnings of the Black-Scholes, Monte Carlo, and lattice models, and how to apply the models when estimating the fair value of employee stock options or other equity awards. While the choice between the Black-Scholes, Monte Carlo simulation, and lattice models is important, the fair value estimates produced by any of these techniques are largely dependent upon the assumptions used. The assumptions usually have a greater impact on fair value than the choice of model. Developing assumptions for use in an option-pricing or equity valuation model is discussed in SC 9.