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Company Options
(Part I)
by WealthEffect Staff

  
 
Two of the clearest mistakes in the determination of a company's earnings per share have been the accounting rules for goodwill amortization and for company stock options. Beginning in 2002, the accounting for goodwill amortization was corrected, with amortization no longer treated as an expense. And, finally, beginning in the 2nd half of 2005, the estimated cost of options will be deducted from earnings on the income statement.		  
 

Company options are not ordinary stock options		  
  Company options are designed to motivate  
  These options are more expensive than shareholders realize  
 
1.
Options granted by companies give managers and employees to right to buy stock. This right allows them to buy a specified number of company shares at a specified price known as the exercise price. If the stock falls below the exercise price, the holder of the option loses nothing — he or she simply declines to exercise the option. There is only a right to buy shares, not an obligation. If, on the other hand, the stock rises above the exercise price, the option holder will make a profit equal to the spread between the market price and the exercise price.

Options available to company executives are very different from those available to you or me. For us, options cost money and they usually expire worthless within 3-6 months. For company executives, options are given free of charge and they are usually worth a fortune.

Why the difference? Company options, as a general rule, don't expire for ten years! It's hard to avoid making a profit when a company's stock has a decade in which to rise.

  
 
2.
Company options are given to senior executives by the Board of Directors. These executives, in turn, decide how many options to give to employees. The motive is motivation, the reasoning being that people will care more about their company's stock price if they are stockholders themselves.

The flaw in the reasoning is that they are not stockholders — they are option holders. Unlike normal shareholders, they didn't pay anything up-front and they have no risk of loss. It's "heads, they win: tails, they break even". Sometimes, it's even "tails, they win." When the stock price declines, some companies will reduce the exercise price of the options — in those cases, if the stock price only returns to where it was before, the option-holders make a nice profit.

  
 
3.
These options have real value — if they were offered to the public, people would pay serious money for them. Accordingly, giving them to executives and employees for free must come out of someone's pocket. As you might guess, that pocket is the shareholders'. What you probably would never guess is just how great the cost is.		  
 
Company Options
(Part II)		  
 

The benefits of company options are overstated		  
  The true costs of these options are understated  
  The costs vary widely from company to company  
 
1.
The problem is simple: company options are given each year as compensation for that year's work, but these options give the holder a portion of the company's profits for the rest of time! The solution is simple, as well: companies could compensate their managers and employees each year with a share of that year's profits.

But no, say the senior managers who, proportionally, get the biggest chunk of each year's options. We want to motivate our people. They will care more about the stock price if they directly benefit from its success. If you accept this argument, however — and virtually every Board of Directors in this country has — then you should want company employees to own stock, not options. If a potential profit will motivate, then a potential loss will only motivate more. Why not pay executives and employees generously, but give them a portion of their compensation in stock?

For those companies which fear their employees will sell their shares and leave, compensation can take the form of restricted stock. These shares can be set aside for a certain number of years. At that time, the employee will receive the stock, but only if still with the company.

  
 
2.
The true costs of options are not recognized on the financial statements. Accounting rules allow companies to recognize these options as a modest increase in the number of shares outstanding, but do not require them to reflect their true value. Remember, benefits given to employees, whether deserved or not, are a cost to shareholders. This is no different with options than with salaries and bonuses.

For example, consider a company which issues options each year to its managers and employees allowing them to buy 5% of the company. On the income statement, the number of fully-diluted shares will increase by 5%. If the shareholders owned 100% of the company before, now they own 95% — not a big deal. If this continues for twenty years, however, the shareholders will own less than 40% of the company! Because, as an investor, you would like to own shares in the right company for decades, this should matter a great deal to you.

  
 
3.
Different companies have differing approaches to stock options. A very few are opposed to options for the reasons discussed. The rest give options to varying degrees. For some, the true cost to shareholders is insignificant relative to earnings. For many, the hidden cost is huge. For investors who are determined to know the costs, the first step begins with the annual report.		  
 
 
As a bonus, you can run some projections of stock performance under various assumptions using the Stock Valuator at www.wealtheffect.com/stockhop/index.asp. To make your projections more realistic, reduce each company's earnings per share for the impact of company stock options when using this calculator.

Dan Stone is the Managing Editor of www.WealthEffect.com and the Director of Research for Steven Charles Capital (www.scharles.com).