It’s an often-overlooked truth, but the ability for investors to accurately see what’s going on in a business and to be able to compare companies based on the same metrics is one of the most important parts of investing. The debate over how to account for corporate stock options offered to employees and executives has been discussed in the media, company boardrooms, and even in the US Congress. After many years of disputes, The Financial Accounting Standards Board, or FASB, issued FAS Statement 123 (r), which requires mandatory spending of stock options beginning in the company’s first fiscal quarter after June 15, 2005.
Investors must learn to identify which companies will be most affected, not only in the form of short-term earnings reviews, or gaap versus pro forma earnings, but also through long-term changes in compensation methods and the effects that the resolution on the long-term strategies of many companies to attract talent and motivate employees.
A brief history of the stock option as compensation
The practice of giving stock options to company employees is decades old. In 1972, the Accounting Principles Board (APB) issued opinion n. 25, which asked companies to use an intrinsic value methodology to value stock options granted to company employees. Under the intrinsic value methods used at the time, companies could issue “money” stock options without recording any expense on their income statements, as the options were considered to have no initial intrinsic value. (In this case, the intrinsic value is defined as the difference between the concession price and the market price of the share, which at the time of the concession would be the same).So while the practice of not posting any cost for stock options started a long time ago, the number that was released was so small that many 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 the use of stock options as a form of compensation really begins to take off. Coinciding with this increase in option granting is a bull market in stocks, specifically technology-related stocks, benefiting from innovations and increased investor demand.
Soon enough, not only top executives were given stock options, but also rank employees. The stock option went from being a backroom executive favor to a complete competitive advantage for companies wanting to attract and motivate top talent, especially young talent who didn’t mind having some options full of possibilities (in gist, lottery tickets) instead of extra money, come on payday. But thanks to the boom in the stock market, instead of lottery tickets, the options given to employees were as good as gold.This provided a key strategic advantage for smaller companies with shallow pockets, who could save their cash and simply issue more and more options, without recording a penny of the transaction as an expense.
Warren Buffet posited on the state of affairs in his 1998 letter to shareholders: “Although options, if properly structured, can be an appropriate and even ideal way to compensate and motivate senior managers, they are more often extremely capricious in their distribution of rewards, inefficient as motivators and excessively expensive for shareholders ”.
It’s time for evaluation
Despite running a hot streak, the “lottery” finally ended, and abruptly. the technology-driven bubble in the stock market burst and millions of once profitable options were rendered useless or “under water.” Corporate scandals dominated the media as the overwhelming greed seen in companies like Enron, Worldcom and Tyco reinforced the need for investors and regulators to regain control of proper accounting and reporting.
Undoubtedly, at the Fasb, the main regulatory body for accounting standards in the United States, they had not forgotten that stock options are an expense with real costs for both companies and shareholders.
What are the costs?
The costs that stock options can pose to shareholders are the subject of much debate. According to the Fasb, no specific method is being imposed on companies to value option grants, mainly because the “best method” has not been determined.
Stock options granted to employees have key differences from those sold on exchanges, such as acquisition periods and lack of transferability (only the employee can use them). In its declaration along with the resolution, the fasb will allow any valuation method, as long as it incorporates the key variables that make up the most widely used methods, such as black studies and binomial models. The key variables are:
- The risk-free rate of return (generally a three- or six-month t-invoice rate will be used).
- The expected dividend rate for the security (company).
- Implied or expected volatility in the underlying security over the term of the option.
- The 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 to by their auditors. Still, there can be surprisingly large differences in final 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 happened, and that is that many companies have reduced, adjusted or completely eliminated their existing stock option programs.Faced with the prospect of having to include estimated costs at the time of concession, many companies have chosen to switch quickly.
Consider the following statistic: Stock option grants granted by S&P 500 companies fell from 7.1 billion in 2001 to just 4 billion in 2004, a decrease of more than 40% in just three years. The chart below highlights this trend.
Figure 1
Source: reuters basics
The slope of the graph is exaggerated due to the decline in earnings during the 2001 and 2002 bear market, but the trend remains undeniable, not to mention dramatic. We are now seeing new compensation and incentive pay models for managers and other employees through restricted stock awards, operational target bonuses, and other creative methods. it’s only in the early stages, so we can expect to see adjustments and true innovation over time.
What investors should expect
Exact figures vary, but most estimates for the S&P expect a total reduction in gap net earnings due to a 3-5% share option expense for 2006, the first year all companies companies will report under the new guidelines. some industries will be hit harder than others, especially the tech industry, and nasdaq shares will show a higher aggregate decline than nyse shares. Consider that just nine industries will account for more than 55% of total options spending for the s & p 500 in 2006:
Figure 2
Source: Credit Suisse First Boston: Building a New Consensus: Stock Option Spending to Lower Analyst Estimates
Trends like this could cause some rotation of the sector towards industries where the percentage of net income “in danger” is lower, as investors determine which companies will be the most affected in the short term.
It’s crucial to note that since 1995, stock option spending has been reported in 10-q and 10-k forms, they were buried in footnotes, but they were there. Investors can search the section titled “share-based compensation” or “stock option plans” to find important information on the total number of options available to the company to grant or acquisition periods and possible dilutive effects on shareholders.
As a review for those who might have forgotten, each option that an employee converts to a stock dilutes the percentage of ownership of all other shareholders in the company. Many companies that issue a large number of options also have share buyback programs to help offset the dilution, but that means they are paying cash to buy back shares that have been given free to employees; These types of share buybacks should be viewed as a compensation cost to employees, rather than an outpouring of love for the average shareholders of corporate coffers.
The toughest proponents of efficient market theory will say that investors need not worry about this accounting shift; As the figures have already been in the footnotes, the argument is that the stock markets will have already incorporated this information into the stock prices. Whether you subscribe to this belief or not, the fact is that many well-known companies will have their net earnings, based on a gap, reduced by much more than the market averages of 3 to 5%. As with the previous industries, the results of individual actions will be highly skewed, as can be shown in the following examples:
Figure 3
Source: Bear Stearns: 2004 earnings impact of stock options on S&P 500 and 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 paying their costs before the deadline; They should be applauded for their efforts. They have the added advantage of two or three years to design new compensation structures that satisfy both employees and people.
Tax benefits: another vital component
It is important to understand that while most companies did not record any expense for their option grants, they were receiving a useful benefit on their income statements in the form of valuable tax deductions. When employees exercised their options, the intrinsic value (market price minus concession price) at the time of exercise was claimed by the company as a tax deduction. These tax deductions were recorded as operating cash flow; These deductions will still be allowed, but will now be counted as a financial cash flow rather than an operating cash flow. This should make investors wary;Not only will EPS gaap be lower for many companies, but operating cash flow will also decrease. just how much As with the earnings examples above, some companies will be hit much harder than others. As a whole, the s & p would have shown a 4% reduction in operating cash flow in 2004, but the results are asymmetric, as the examples below illustrate:
Figure 4
Source: Bear Stearns: 2004 earnings impact of stock options on S&P 500 and Nasdaq 100 earnings
As the listings above reveal, companies whose shares had appreciated significantly over the time period received an above-average tax gain because the intrinsic value of the options at expiration was higher than expected in the company’s original estimates. With this benefit erased, another critical investment metric will be changing for many companies.
What to look for in wall street
There is no real consensus on how large brokerage firms will cope with change once it has proliferated across all public companies. Analyst reports are likely to show both earnings per share (EPS) and EPS figures that are not gaps in both reports and estimates / models, at least for the first few years. Some companies have already announced that they will require all analysts to use gap eps figures in reports and models, which will represent options compensation costs. Additionally, data firms have said they will start incorporating option spending into their earnings and cash flow figures across the board.
The bottom line
At best, stock options still provide a way to align the interests of employees with those of senior management and shareholders, as the payoff grows with the price of a company’s stock. however, it is often too easy for one or two executives to artificially inflate short-term earnings, either by dragging the benefits of future earnings into current earnings periods or through outright manipulation. This transition period in the markets is a great opportunity to assess both company management and investor relations teams on things like their frankness, their corporate governance philosophies and whether they stand up for shareholder values.
If we are to trust the markets in any respect, we must trust their ability to find creative ways to solve problems and digest changes in the market. Option prizes became increasingly attractive and lucrative because the loophole was too great and tempting to ignore. Now that the loophole is closing, companies will have to find new ways to give incentives to employees. Clarity in accounting and investor reporting will benefit all of us, even if the short-term outlook gets blurry from time to time.
