The Advantages And Value Of Stock Options

It’s an often-overlooked truth, but the flexibility for investors to accurately see what is occurring at an organization and to find a way to check corporations based on the identical metrics is one of the vital parts of investing. The talk about the best way to account for corporate stock options given to employees and executives has been argued within the media, company boardrooms, and even within the U.S. Congress. After a few years of squabbling, the Financial Accounting Standards Board, or FASB, issued FAS Statement 123 (R), which calls for the mandatory expensing of stock options starting in the primary company fiscal quarter after June 15, 2005.

Investors must learn the best way to discover which corporations will probably be most affected—not only in the shape of short-term earnings revisions, or GAAP versus pro forma earnings—but additionally by long-term changes to compensation methods and the consequences the resolution may have on many firms’ long-term strategies for attracting talent and motivating employees.

A Short History of the Stock Option as Compensation

The practice of giving out stock options to company employees is a long time old. In 1972, the Accounting Principles Board (APB) issued opinion No.25, which called for corporations to make use of an intrinsic value methodology for valuing the stock options granted to company employees. Under intrinsic value methods used on the time, corporations could issue “at-the-money” stock options without recording any expense on their income statements, as the choices were considered to haven’t any initial intrinsic value. (On this instance, intrinsic value is defined because the difference between the grant price and the market price of the stock, which on the time of grant can be equal). So, while the practice of not recording any costs for stock options began way back, the number being handed out was so small that lots of people ignored it.

Fast-forward to 1993; Section 162m of the Internal Revenue Code is written and effectively limits corporate executive money compensation to $1 million per yr. It’s at this point that using stock options as a type 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 advantages 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 corporations wishing to draw and motivate top talent, especially young talent that did not mind getting a couple of options filled with likelihood (in essence, lottery tickets) as a substitute of additional money come payday. But because of the booming stock market, as a substitute of lottery tickets, the choices granted to employees were nearly as good as gold. This provided a key strategic advantage to smaller corporations with shallower pockets, who could save their money and easily issue increasingly options, all of 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, might be an appropriate, and even ideal, option to compensate and motivate top managers, they’re more often wildly capricious of their distribution of rewards, inefficient as motivators and inordinately expensive for shareholders.”

It’s Valuation Time

Despite having run, the “lottery” eventually ended—and abruptly. The technology-fueled bubble within the stock market burst and hundreds of thousands of options that were once profitable had turn out to be worthless, or “underwater.” Corporate scandals dominated the media, because the overwhelming greed is seen at corporations like Enron, Worldcom and Tyco reinforced the necessity for investors and regulators to take back control of proper accounting and reporting.

To ensure, over on the FASB, the major regulatory body for U.S. accounting standards, that they had not forgotten that stock options are an expense with real costs to each corporations and shareholders.

What Are the Costs?

The prices that stock options can pose to shareholders are a matter of much debate. In keeping with the FASB, no specific approach to valuing options grants is being forced on corporations, primarily because no “best method” has been determined.

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

Corporations are allowed to make use of their very own discretion when selecting a valuation model, nevertheless it must even be agreed upon by their auditors. Still, there might be surprisingly large differences in ending valuations depending on the tactic used and the assumptions in place, especially the volatility assumptions. Because each corporations and investors are entering latest territory here, valuations and methods are certain to alter over time. What is understood is what has already occurred, and that’s that many corporations have reduced, adjusted or eliminated their existing stock options programs altogether. Faced with the prospect of getting to incorporate estimated costs on the time of granting, many firms have chosen to alter fast.

Consider the next 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 greater than 40% in only three years. The chart below highlights this trend.

Figure 1

Source: Reuters Fundamentals

The slope of the graph is exaggerated due to depressed earnings through the bear market of 2001 and 2002, however the trend remains to be undeniable, not to say dramatic. We are actually seeing latest models of compensation and incentive-pay to managers and other employees through restricted stock awards, operational goal bonuses and other creative methods. It’s just at first phases, so we will expect to see each tweaking and true innovation with time.

What Investors Should Expect

Exact figures vary, but most estimates for the S&P expect a complete reduction in net GAAP earnings as a consequence of stock options expensing of between 3 to five% for 2006, the primary yr by which all corporations will probably be reporting under the brand new guidelines. Some industries will probably be more affected than others, most notably the tech industry, and Nasdaq stocks will show a better aggregate reduction than NYSE stocks. Consider that only nine industries will make up greater than 55% of the full options expensing for the S&P 500 in 2006:

Figure 2

Source: Credit Suisse First Boston: Constructing a Recent Consensus: Expensing Stock Options to Drive Analysts’ Estimates Lower

Trends like this might cause some sector rotation toward industries where the proportion of net income “in peril” is lower, as investors sort out which businesses will probably be hurt essentially the most within the short term.

It’s crucial to notice that since 1995, stock options expensing has been contained in SEC Form 10-Q and 10-K reports—they were buried within the footnotes, but they were there. Investors can look within the section often titled “Stock-Based Compensation” or “Stock Options Plans” to seek out vital details about the full variety of options at the corporate’s disposal to grant or the vesting periods and potential dilutive effects on shareholders.

As a review for individuals who may need forgotten, every option that’s converted right into a share by an worker dilutes the proportion of ownership of each other shareholder in the corporate. Many corporations that issue large numbers of options even have stock repurchase programs to assist offset dilution, but meaning they’re paying money to purchase back stock that has been given out totally free to employees—these kind of stock repurchases needs to be checked out as a compensation cost to employees, moderately than an outpouring of affection for the typical shareholders from flush corporate coffers.

The toughest proponents of efficient market theory will say that investors needn’t worry about this accounting change; for the reason that figures have already been within the footnotes, the argument goes, stock markets may have already incorporated this information into share prices. Whether you subscribe to this belief or not, the very fact is that many well-known corporations may have their net earnings, on a GAAP basis, reduced by way more than the market averages of three to five%. As with the industries above, individual stock results will probably be highly skewed, as might be shown in the next examples:

Figure 3

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

To be fair, many corporations (about 20% of the S&P 500) decided to scrub their windshields early and announced that they’d start expensing their costs prior to the deadline; they needs to be applauded for his or her efforts. They’ve the additional advantage of two or three years to design latest compensation structures that satisfy each employees and the FASB.

Tax Advantages: One other Vital Component

It is crucial to grasp that while most corporations weren’t recording any expenses for his or her option grants, they were receiving a handy profit on their income statements in the shape of worthwhile tax deductions. When employees exercised their options, the intrinsic value (market price minus grant price) on the time of exercise was claimed as a tax deduction by the corporate. These tax deductions were being recorded as operating money flow; these deductions will still be allowed, but will now be counted as a financing money flow as a substitute of operating money flow. This could make investors wary; not only is GAAP EPS going to be lower for a lot of corporations, operating money flow will probably be falling as well. Just how much? Like with the earnings examples above, some corporations will probably be hurt way more than others. As a complete, the S&P would have shown a 4% reduction of operating money flow within the yr 2004, but the outcomes are skewed, because 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

Because the listings above reveal, corporations whose stocks had appreciated significantly through the time period received an above-average tax gain since the intrinsic value of the choices at expiration was higher than expected in the unique company estimates. With this profit erased, one other fundamental investing metric will probably be shifting for a lot of corporations.

What to Search for From Wall Street

There isn’t a real consensus on how the big brokerage firms will cope with the change once it has been proliferated to all public corporations. Analyst reports will likely show each GAAP earnings per share (EPS) and non-GAAP EPS figures in each reporting and estimates/models, not less than through the first couple of years. Some firms have already announced that they’ll require all analysts to make use of the GAAP EPS figures in reports and models, which is able to account for the choices compensation costs. Also, data firms have said that they’ll begin incorporating the choices expense into their earnings and money flow figures across the board.

The Bottom Line

At their best, stock options still provide a option to align worker interests with those of upper management and the shareholders, because the reward grows in with the value of an organization’s stock. Nevertheless, it is commonly far too easy for one or two executives to artificially inflate short-term earnings, either by pulling future earnings advantages into present earnings periods or via flat-out manipulation. This transition period within the markets is an amazing likelihood to guage each company management and investor relations teams on things resembling their frankness, their corporate governance philosophies and in the event that they uphold shareholder values.

If we should always trust the markets in any regard, we should always depend on its ability to seek out creative ways to unravel problems and digest changes within the marketplace. Options awards became increasingly attractive and lucrative since the loophole was just too big and tempting to disregard. Now that the loophole is closing, corporations may have to seek out latest ways to offer employees incentives. Clarity in accounting and investor reporting will profit us all, even when the short-term picture becomes fuzzy every now and then.

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