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Markets: Taking Stock
New York: September 20, 2004
By John R. Stephenson

A gathering storm is on the horizon that should continue to be hotly debated in the months and years to come. At the center of this storm is the discussion about company stock options (a stock option is the right to acquire a share of company stock at a predetermined price) and whether or not they are in fact a form of employee compensation. Currently, stock options don’t show up on a company’s financial statements which masks their true cost. If you want to try and determine their true cost, you’ll need to seach the footnotes to the financial statements for clues. But why is this a big deal? Because exposing the true cost of stock options by placing them on the income statement would cause corporate earnings to suffer. For that reason, most of corporate America is against the expensing of stock options but an equally powerful contingent comprised of Alan Greenspan (the Chairman of the Fed), Warren Buffett and the Financial Accounting Standards Board (FASB) are in favor of expensing stock options.

Many firms use stock option grants to help lure high caliber employees to join their ranks by promising them a piece of the action. The thinking goes that, if the company does well, then that should be reflected in the stock price. As the stock price increases, say from $5/share to $45/share, those stock options that the company granted to their employees (back when the company stock was trading for $5/share) can become really valuable. A vested stock option with an exercise price well below the current market price is like money in the bank for employees. Employees who hold "in the money" stock options can exercise their options by buying shares in the company at the reduced price (the strike price of the option) and turn around and sell that same stock at the market price, thereby pocketing a tidy profit. If, in the above example, an employee holds the rights to acquire 100 shares at $6/share and the stock is currently trading at $45/share the employee can opt to exercise the option (by paying $6/share x 100 shares) and then immediately turn around and sell those same shares in the market at the current market price ($45/share x 100 shares) for a instant profit of $3,900.

Not only can stock options be a bonanza for employees who hold, in many cases, thousands of dollars of stock-based compensation in the form of these options, but under the current accounting regime, these options are costless to the corporations that issue them. The reason

that options are a costless form of compensation is that they offer real economic benfit to employees and yet the expense associated with this compensation shows up only as estimates in the footnotes to the financial statements and doesn't appear as a line item on the income statement. The net effect? That net income (and earnings per share) appears higher than it otherwise would if the cost of all forms of employee compensation (i.e. stock options) were included. Of course, there is a loser in this equation and that is the shareholder of companies with large stock option grants, because every time an employee exercises a stock option and acquires shares below market value they dilute the value of the shares of the existing shareholders. In effect, stock options once exercised represent a transfer of wealth from the existing shareholders to the employees who are exercising their stock options.

Both international pressure to harmonize accounting treatment and domestic pressure to make financial statements more transparent has resulted in a movement towards expensing the true cost of stock options. In fact, on March 31 of this year, the Financial Accounting Standards Board (FASB — the organization that sets the accounting rules for publicly listed companies), issued an exposure draft entitled “Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95.” This draft calls for the expensing of stock options and has touched off a firestorm of protests particularly in Silicon Valley and Washington D.C.

The forces lining up in favor of the status quo argue that the expensing of stock options would result in jobs being moved overseas since stock options represent a form of competitive advantage. As well, they argue that there is no way to accurately value stock options and therefore by including their estimated cost on future financial statements, these statements will be less comprehensible rather than more so.

But the forces in favor of expensing stock options are nothing to sneeze at. Some of those that are in favor of expensing stock options include Alan Greenspan (Chairman of the U.S. Federal Reserve) and Warren Buffet. As Warren Buffett would say "if they (stock options) are not compensation then what are they?" Given the pressure from the international financial community and the spate of recent corporate frauds it seems to be a virtual certainty that stock options will be expensed in the future. The likely result? For companies with large stock option grants the expensing of options will be like taking a sledgehammer to earnings. If companies have to start expensing the full cost of compensation (by properly accounting for the effects of stock options), their reported earnings will drop because of this new expense. With the strong possibility of companies reporting lower future earnings, it seems likely that some high-flying stocks will come back down to earth.

Figure 1: Options Outstanding Exceeding 10% of Shares Outstanding

Source: Company Data, CSFB Estimates

But just how big a deal is the expensing of stock options anyway? As it turns out, it is pretty big. In June of this year, Credit Suisse First Boston ("CSFB"), an investment bank, took a stab at quantifying the size of the problem. Their conclusions? That currently there are a total of 28 billion employee stock options outstanding among the companies in the S&P 500 and the estimated fair value of these options is $347 billion. That's $347 billion that would, under the proposed rules, be hitting the income statements of America's largest corporations and causing a reduction in earnings. With the proposed rules slated to go into effect at the beginning of 2005, investors should look for earnings to slow in companies that have huge stock option grants outstanding as the stock market anticipates the reduction in reported earnings which will accompany the expensing of options.

Figure 2: The Effect on Net Income if Stock Options Were Expensed (Previous Three Years)

Source: Company Data, CSFB Estimates

Investors would be wise to review the companies in their portfolio to determine if they have large outstanding stock option grants and, if so, what would be the likely impact on the price of their stocks if these stock options were to be treated as employee compensation. When CSFB examined the issue, they determined that the types of companies with the greatest exposure to this new regulation were: Internet Software and Services Companies, Internet & Catalog Retailers, Software, Semiconductors, Biotechnology, Electronic Equipment & Instruments and Communications Equipment providers. It is these companies that have the largest claim on the shareholders' stake and that could perform poorly when the new year rolls around.



StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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