Ask any roomful of investors
what most influences stock prices, and aside from the two guys obsessed with
Greenspan's next move, the rest will say corporate profits. With apologies
to the Fed chairman, the majority would be correct. Yet we're often made
aware of the way earnings get massaged by management to satisfy the Street's
expectations. Play with the numbers too much, and you end up in the hoosegow.
Play with them just enough, and you click off the predictable quarterly growth
of a COCA-COLA (NYSE: KO), regardless of whether sales in Brazil had
any fizz or not.
A Compromise Found
A Senator Speaks Out
A Dynamic Worth
Earnings are everything, the solid reality of the bottom line that we use
in our financial models to determine a company's value. Yet they are also
mere fictions, tales that we've all agreed to believe as long as they follow
certain widely accepted conventions. Lest you mistake this for just a strained
analogy, those conventions are known as the Generally Accepted Accounting
Principles (GAAP), and they are put in place by the Financial Accounting
Standards Board (FASB), which the Securities and Exchange Commission (SEC)
more or less defers to on these matters. The FASB has the power to change
our very understanding of corporate earnings. Indeed, they may have already
done so thanks to the added corporate disclosure required by recent rule
changes regarding the treatment of stock options.
Stock options are the bete noir of corporate America. Hardly a week goes
by that we don't hear of yet another top executive who's made off like a
high-class bandit despite stringing together a series of lackluster results.
Then again, options seem quintessentially American, aligning management and
sometimes even employees with shareholders while rewarding risk-taking and
stellar performance with mind-boggling riches. It seems thoroughly appropriate,
even good, that Seattle should be teeming with MICROSOFT (Nasdaq: MSFT) millionaires. Only in America.
Most folks aren't opposed to options per se but to the way corporate boards
dish them out as if no one has to pay for them. Of course, that is one huge
reason why compensation packages are chock full of such generous options
awards: the company doesn't have to pay for them, at least not up front.
Options are tickets to ride, not cash, so they don't get subtracted from
a firm's income. Since companies need cash to build the business, better
to hand out stubs now, cash later, if at all. Better yet, companies actually
profit from these non-payment payments by expensing the costs to gain lucrative
tax advantages. The confusing result may not make much sense, but it's the
way things have worked for a while now. At the center of the confusion is
the simple question: How should we calculate earnings?
Part 2: A Virtual Example
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