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Friday, April 30, 1999

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Optionmania!

Over my next three Fool On The Hill (FOTH) columns, I'm going to look at the proliferation of option grants and how they affect (or really, don't affect) a company's financial statements. Very little attention is paid to this subject in the mass media or by investment professionals. At some point, however, people will likely consider the amount of options expended to be an important investment consideration. As Fools, we want to be ahead of the crowd, rather than fall behind it.

Employee stock options are pretty easy to understand. They provide employees the right, but not the obligation, to purchase shares of their employer's stock at a certain price for a certain period of time. Options are usually granted at the current market price of the stock and last for up to 10 years. To encourage employees to stick around and help the company grow, options typically carry a four to five year vesting period, but each company sets its own parameters. With the rousing gains in the stock market over the past two decades, options have become a highly sought after compensation mechanism. Many employees will not consider joining a company unless options are included.

Let's consider Sally, who's getting ready to graduate from college and is looking for a new job. She has offers from two companies, New Age Compensation and Old Line Compensation, for similar positions. The salary from New Age is $10,000 lower than the one from Old Line, but New Age dangles options on 2,000 shares as an incentive for Sally to join the firm. Sally decides to accept the job from New Age, believing that her total compensation, incorporating the probable ultimate value of her options, will be higher than the offer from Old Line.

The value Sally reaps from the option will not be determined until she disposes of the option through exercise or expiration. If New Age stock does well, she could make lots of dough. On the other hand, the stock price could go nowhere for ten years, resulting in her options being worthless. While the end result of the option is unknown, Sally must have valued the option grant at more than $10,000, or she wouldn't have decided to join New Age.

The Accounting Rules
Accounting regulators have struggled determining the best way to account for options. On the one hand, they obviously have some value to the employee. On the other hand, companies don't expend cash when they grant options. If an employee exercises an option, the company just issues a new share of stock. Instead of a cash outflow, the company actually has an inflow of cash from the exercise price of the stock (although that inflow is less than what would be provided if the share were issued on the open market). The company is basically using its ability to issue shares as a way to print shares and sell them at below-market prices.

Under old accounting rules, companies would only expense an options grant if it had "intrinsic value" on the date of issue. Intrinsic value is the extent to which an options exercise price is below the current market price. If Microsoft (NYSE: MSFT) were to issue options at an exercise price of $50 per share when the stock was trading at $81 per share, those options would have an intrinsic value of $31 ($81-$50) that would be expensed. If, on the other hand, Microsoft issued options with an $81 or higher exercise price, the options would have no intrinsic value and no expense would be recorded. Since most companies issue options at or above market prices, they do not record compensation expenses for these grants.

In 1995, accounting regulators issued a new pronouncement stating that it was preferable to use the "fair value" method of accounting for options rather than "intrinsic value." The fair value of an option can be calculated by using various pricing techniques developed on Wall Street to value traded options. While numerous assumptions must go into these calculations, they provide a rough approximation for what companies would expend to issue options.

Bowing to outside pressure, particularly from upstarts that rely heavily on options as a compensation tool, accounting regulators put a loophole into the 1995 pronouncement. Companies could continue using the "intrinsic value" method of accounting for options, so long as they included a footnote in their annual report stating the cost of options under the "fair value" method. With this loophole, very few (if any) companies have adopted the "fair value" method of accounting for options in their financial statements. Instead, they continue using the "intrinsic value" method, including a footnote in their annual statements describing how the implementation of "fair value" accounting would impact net income and earnings per share.

Impact
Going back to our example with Sally, the differing compensation structures would have differing effects on the income statements of the companies involved. As mentioned, New Age and Old Line are similar to each other. Both had prior year revenue and expenses of $1 million and $800,000, respectively. Over the next year, revenues rise 10% and expenses are flat at both companies, except for the cost of hiring an additional employee. New Age hires Sally for $25,000 and 2,000 stock options, while Old Line finds someone willing to accept a $35,000 offer with no options.

Below are the income statements for the two companies for the year after Sally's hire:


New Age Old Line
Revenue $1,100,000 $1,100,000
Expenses 800,000 800,000
New Hire 25,000 35,000
Net Income $275,000 $265,000

Earnings Per Share $2.74 $2.65

Diluted Shares 100,400 100,000

(A technical note that you can skip if you aren't detail oriented: Diluted shares outstanding increase by only 400 shares, rather than 2,000 shares, because they are accounted for under the treasury method. Under this technique, proceeds from option exercises are assumed to be used to acquire stock on the open market. In this example, the proceeds of Sally's options exercise would be used to repurchase 1,600 shares at the year-end stock price. Diluted shares would therefore increase by 400 (2,000-1,600) shares. Now back to our regularly scheduled programming.)

Looking at the income statement and reported earnings, New Age looks better than Old Line. The only difference between the two companies, however, is new hire compensation. While New Age is paying less cash compensation, we know that Sally decided to work for New Age because she believed she was receiving higher total pay. Is it fair for New Age to post higher earnings because it used its stock option printing press to pay part of Sally's salary?

Digging through New Age's 10-K, we will find disclosures regarding the value of stock options granted. Assuming Sally's options are worth $5 per share and they vest in the first year, this note would state that the fair value of option grants were $10,000. Incorporating that expense, this disclosure would detail that New Age's adjusted net income was $265,000 and earnings per share was $2.64 (the number or shares outstanding would remain 100,400). Someone using this disclosure would see that adjusted for option compensation, New Age is actually less profitable than Old Line.

Does the difference in reported earnings and option expense-adjusted earnings matter? I'll be tackling that issue and others in my next two FOTHs. In addition, I'll go beyond the hypothetical examples of New Age and Old Line to see what the footnotes from real companies say. How do option grants impact the income statements of Microsoft, Dell Computer (Nasdaq: DELL), T. Rowe Price (Nasdaq: TROW), and others? Stay tuned. Until then, have a Foolish weekend!

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