It is an often-overlooked truth, but the ability for investors to accurately see what is going on at a company and to be able to compare companies based on the same metrics is one of the most vital parts of investing.

TUTORIAL: Stock Picking Strategies

The debate about how to account for corporate stock options given to employees and executives has been argued in the media, company boardrooms and even in the U.S. Congress. After many years of squabbling, the Financial Accounting Standards Board, or FASB, issued FAS Statement 123 (R), which calls for the mandatory expensing of stock options beginning in the first company fiscal quarter after June 15, 2005. (To learn more, see The Dangers Of Options Backdating. The "True" Cost Of Stock Options and A New Approach To Equity Compensation.)

Investors need to learn how to identify which companies will be most affected - not only in the form of short-term earnings revisions, or GAAP versus pro forma earnings - but also by long-term changes to compensation methods and the effects the resolution will have on many firms' long-term strategies for attracting talent and motivating employees. (For related reading, see Understanding Pro-Forma Earnings.)

A Short History of the Stock Option as Compensation
The practice of giving out stock options to company employees is decades old. In 1972, the Accounting Principles Board (APB) issued opinion No.25, which called for companies to use an intrinsic value methodology for valuing the stock options granted to company employees. Under intrinsic value methods used at the time, companies could issue "at-the-money" stock options without recording any expense on their income statements, as the options were considered to have no initial intrinsic value. (In this instance, intrinsic value is defined as the difference between the grant price and the market price of the stock, which at the time of grant would be equal). So, while the practice of not recording any costs for stock options began long ago, the number being handed out was so small that a lot of people ignored it.

Fast-forward to 1993; Section 162m of the Internal Revenue Code is written and effectively limits corporate executive cash compensation to $1 million per year. It is at this point that using stock options as a form of compensation really starts to take off. Coinciding with this increase in options granting is a raging bull market in equities, specifically in technology-related stocks, which benefits from innovations and heightened investor demand.

Pretty soon it wasn't just top executives receiving stock options, but rank-and-file employees as well. The stock option had gone from a back-room executive favor to a full-on competitive advantage for companies wishing to attract and motivate top talent, especially young talent that didn't mind getting a few options full of chance (in essence, lottery tickets) instead of extra cash come payday. But thanks to the booming stock market, instead of lottery tickets, the options granted to employees were as good as gold. This provided a key strategic advantage to smaller companies with shallower pockets, who could save their cash and simply issue more and more options, all the while not recording a penny of the transaction as an expense.

Warren Buffet postulated on the state of affairs in his 1998 letter to shareholders: "Though options, if properly structured, can be an appropriate, and even ideal, way to compensate and motivate top managers, they are more often wildly capricious in their distribution of rewards, inefficient as motivators and inordinately expensive for shareholders."

It's Valuation Time
Despite having a good run, the "lottery" eventually ended - and abruptly. The technology-fueled bubble in the stock market burst, and millions of options that were once profitable had become worthless, or "underwater." Corporate scandals dominated the media, as the overwhelming greed seen at companies like Enron, Worldcom and Tyco reinforced the need for investors and regulators to take back control of proper accounting and reporting. (To read more about these events, see The Biggest Stock Scams Of All Time.)

To be sure, over at the FASB, the main regulatory body for U.S. accounting standards, they had not forgotten that stock options are an expense with real costs to both companies and shareholders.

What Are the Costs?
The costs that stock options can pose to shareholders are a matter of much debate. According to the FASB, no specific method of valuing options grants is being forced on companies, primarily because no "best method" has been determined.

Stock options granted to employees have key differences from those sold on the exchanges, such as vesting periods and lack of transferability (only the employee can ever use them). In their statement along with the resolution, the FASB will allow for any valuation method, so long as it incorporates the key variables that make up the most commonly used methods, such as Black Scholes and binomial. The key variables are:

  • The risk-free rate of return (usually a three- or six-month t-bill rate will be used here).
  • Expected dividend rate for the security (company).
  • Implied or expected volatility in the underlying security during the option term.
  • Exercise price of the option.
  • Expected term or duration of the option.

Corporations are allowed to use their own discretion when choosing a valuation model, but it must also be agreed upon by their auditors. Still, there can be surprisingly large differences in ending valuations depending on the method used and the assumptions in place, especially the volatility assumptions. Because both companies and investors are entering new territory here, valuations and methods are bound to change over time. What is known is what has already occurred, and that is that many companies have reduced, adjusted or eliminated their existing stock options programs altogether. Faced with the prospect of having to include estimated costs at the time of granting, many firms have chosen to change fast.

Consider the following statistic: Grants of stock options given out by S&P 500 firms fell from 7.1 billion in 2001 to only 4 billion in 2004, a decrease of more than 40% in just three years. The chart below highlights this trend.

Figure 1
Source: Reuters Fundamentals

The slope of the graph is exaggerated because of depressed earnings during the bear market of 2001 and 2002, but the trend is still undeniable, not to mention dramatic. We are now seeing new models of compensation and incentive-pay to managers and other employees through restricted stock awards, operational target bonuses and other creative methods. It's just in the beginning phases, so we can expect to see both tweaking and true innovation with time.

What Investors Should Expect
Exact figures vary, but most estimates for the S&P expect a total reduction in net GAAP earnings due to stock options expensing of between 3 to 5% for 2006, the first year in which all companies will be reporting under the new guidelines. Some industries will be more affected than others, most notably the tech industry, and Nasdaq stocks will show a higher aggregate reduction than NYSE stocks. Consider that only nine industries will make up more than 55% of the total options expensing for the S&P 500 in 2006:

Figure 2
Source: Credit Suisse First Boston: Building a New Consensus: Expensing Stock Options to Drive Analysts\' Estimates Lower

Trends like this could cause some sector rotation toward industries where the percentage of net income "in danger" is lower, as investors sort out which businesses will be hurt the most in the short term.

It is crucial to note that since 1995, stock options expensing has been contained in 10-Q and 10-K reports - they were buried in the footnotes, but they were there. Investors can look in the section usually titled "Stock-Based Compensation" or "Stock Options Plans" to find important information about the total number of options at the company's disposal to grant or the vesting periods and potential dilutive effects on shareholders.

As a review for those who might have forgotten, every option that is converted into a share by an employee dilutes the percentage of ownership of every other shareholder in the company. Many companies that issue large numbers of options also have stock repurchase programs to help offset dilution, but that means they're paying cash to buy back stock that has been given out for free to employees - these types of stock repurchases should be looked at as a compensation cost to employees, rather than an outpouring of love for the average shareholders from flush corporate coffers.

The hardest proponents of efficient market theory will say that investors needn't worry about this accounting change; since the figures have already been in the footnotes, the argument goes, stock markets will have already incorporated this information into share prices. Whether you subscribe to this belief or not, the fact is that many well-known companies will have their net earnings, on a GAAP basis, reduced by much more than the market averages of 3 to 5%. As with the industries above, individual stock results will be highly skewed, as can be shown in the following examples:

Figure 3
Source: Bear Stearns: 2004 Earnings Impact of Stock Options on the S&P 500 & Nasdaq 100 Earnings

To be fair, many companies (about 20% of the S&P 500) decided to clean their windshields early and announced that they would start expensing their costs prior to the deadline; they should be applauded for their efforts. They have the extra advantage of two or three years to design new compensation structures that satisfy both employees and the FASB.

Tax Benefits - Another Vital Component
It is important to understand that while most companies were not recording any expenses for their option grants, they were receiving a handy benefit on their income statements in the form of valuable tax deductions. When employees exercised their options, the intrinsic value (market price minus grant price) at the time of exercise was claimed as a tax deduction by the company. These tax deductions were being recorded as an operating cash flow; these deductions will still be allowed, but will now be counted as a financing cash flow instead of an operating cash flow. This should make investors wary; not only is GAAP EPS going to be lower for many companies, operating cash flow will be falling as well. Just how much? Like with the earnings examples above, some companies will be hurt much more than others. As a whole, the S&P would have shown a 4% reduction of operating cash flow in the year 2004, but the results are skewed, as the examples below illustrate quite plainly:

Figure 4
Source: Bear Stearns: 2004 Earnings Impact of Stock Options on the S&P 500 & Nasdaq 100 Earnings

As the listings above reveal, companies whose stocks had appreciated significantly during the time period received an above-average tax gain because the intrinsic value of the options at expiration was higher than expected in the original company estimates. With this benefit erased, another fundamental investing metric will be shifting for many companies.

What to Look for from Wall Street
There is no real consensus on how the large brokerage firms will deal with the change once it has been proliferated to all public companies. Analyst reports will likely show both GAAP earnings per share (EPS) and non-GAAP EPS figures in both reporting and estimates/models, at least during the first couple of years. Some firms have already announced that they will require all analysts to use the GAAP EPS figures in reports and models, which will account for the options compensation costs. Also, data firms have said that they will begin incorporating the options expense into their earnings and cash flow figures across the board. (To read more about EPS, see Types Of EPS and Getting The Real Earnings.)

At their best, stock options still provide a way to align employee interests with those of upper management and the shareholders, as the reward grows in with the price of a company's stock. However, it is often far too easy for one or two executives to artificially inflate short-term earnings, either by pulling future earnings benefits into present earnings periods, or via flat-out manipulation. This transition period in the markets is a great chance to evaluate both company management and investor relations teams on things such as their frankness, their corporate governance philosophies and if they uphold shareholder values. (To read more about manipulated corporate statements, see Cooking The Books 101 and Putting Management Under The Microscope.)

If we should trust the markets in any regard, we should rely on its ability to find creative ways to solve problems and digest changes in the marketplace. Options awards became more and more attractive and lucrative, because the loophole was just too big and tempting to ignore. Now that the loophole is closing, companies will have to find new ways to give employees incentives. Clarity in accounting and investor reporting will benefit us all, even if the short-term picture becomes fuzzy from time to time.

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