Recently, there have been a couple of articles in this space (RM 2/17/00 and RM 2/18/00) discussing some of the issues related to stock options. Tonight, I'm going to jump in with some thoughts of my own.

One important thing to note right off the bat is that options are not completely ignored within a company's financial statements. Outstanding, in-the-money options (i.e., those with an exercise price at or below the stock's current price) are included in a company's diluted sharecount, which thereby impacts the denominator of the diluted earnings per share calculation.

Cisco Systems (Nasdaq: CSCO) serves as a good example. The networker provides full disclosure related to its stock options in Footnote 9 of its financial statements. According to the information presented in this footnote, Cisco's net income for fiscal 1999 would have been approximately 31% lower if all such options had been exercised. Earnings per share would have been approximately 32% lower. Thus, the impact of these options is potentially quite significant. (If you'd like to see how I calculated these numbers, I used the methodology outlined last year in Warren Gump's excellent set of Fool on the Hill articles ("Optionmania!": Part 1, Part 2, Part 3).

The balance sheet and cash flow statement are also affected by the exercise of such stock options. Cash flow can effectively be overstated because the company has compensated employees with a cash substitute rather than actual cash. Similarly, shareholders' equity is understated as the exercise of the option results in increased equity in an amount equal to the exercise price rather than the actual price of the stock at the time of exercise. This can lead to a distortion of the amount of equity capital invested in the business, which has an impact in both Return on Equity (ROE) and Return on Invested Capital (ROIC).

It is important to remember that stock options are an integral part of compensation at many companies, particularly those with valuable stock like Cisco. At the time of grant, stock options also include a number of conditions on the grantee. For example, they normally vest over a period of time, meaning that the employee will have to perform additional services in order to realize the benefits of such options. As a result, many of these options may go unused.

While it is difficult to determine the true impact of stock options on a company's performance, an investor should keep a watchful eye on stock option grants to make sure they are comfortable with the company's use of this important compensation tool.

I'd like to comment on what I believe is at least a partial misconception about options -- the idea that the tax benefits that options provide to companies represent a loophole in the tax system that needs to be changed. To be honest, I can't even begin to agree with that statement.

In my opinion, the tax treatment of options does not represent a true loophole at all. Instead, what you have is a shifting of the tax burden from the corporation to the individual. If you think that this is a loophole, then you should blame the U.S. Congress and not the companies that take advantage of this system.

One of the fundamental accounting principles of the U.S. tax system is the Matching Principle. This means that there should be a matching of income with the expense incurred to obtain that income. In other words, in order for one person or entity to claim a tax deduction, another must pick up income. In the case of stock options, individuals are taxed on the income associated with the option exercise; the corporation gets a deduction.

Let's work through an example of what happens. Say that Diana works for The Joshua Company (Ticker: JOSH). In 1995, she was granted an option to purchase 1,000 shares at a price of $20 per share. The options take five years to vest (meaning that if Diana stopped working for JOSH at ANY time during that five-year period, her options would be worthless. But, since she likes her job and JOSH has performed well, Diana has not changed her job by the time that these options vest.

Now that she is ready to purchase a house and needs some money for the down payment, she has decided to exercise 500 of her options. (Note: This is also a reminder that many times employees exercise stock options or sell stock for personal reasons and not because of any concerns about the company's performance.) These days JOSH is trading at $120 per share. This means that Diana has a taxable profit of $100 per share ($120 - $20) on the 500 options she's exercising for a total gain of $50,000 ($100 x 500). Since this gain is considered ordinary income, it's not taxed at capital gains rates. Let's also assume that after exercising these options Diana finds herself in the 36% tax bracket. She has to pay $18,000 in taxes ($50,000 gain x 36%). This leaves her with $32,000 ($50,000 gain - $18,000 tax) to use towards her down payment.

So, Diana ends up with $50,000 of income and a $18,000 tax bill. On the other hand, JOSH ends up with a $50,000 tax deduction, which is equal to the amount of income Diana has picked up. Assuming that JOSH pays tax at a 35% rate, this means that it saves $17,500 of taxes when Diana exercises her options. You should also note that the federal government actually comes out $500 ahead in this example as JOSH saves $17,500, but Diana pays $18,000.

Like it or not, the reason this transaction is taxed this way is that our tax system is based upon individuals paying the bulk of the tax. (I recently read that corporations are responsible for something like 10-20% of total tax revenues). The other thing to remember is that if Diana wanted to keep this vested stock, then she'd have to come up with the $18,000 to pay the tax bill from some other source. (When an individual exercises her stock options, a big tax hit results. Options normally have a ten-year life. So, even if one holds onto options for ten years, unless she has enough cash to pay the exercise price and the related tax bill on the gain, there's no way to continue to hold all the shares.)

I do realize that JOSH could have increased Diana's base compensation instead of using stock options. This would have resulted in a deduction based upon a cash expenditure as opposed to the paper deduction caused by the stock option exercise. But stock options are meant to reward employees and enable them to share in the success of the companies that they work for.

Many also view our present society as one filled with haves and have-nots. If individuals didn't pay tax on this income, then the highly compensated employees would end up with more tax-free income, which would cause the divergence between the rich and the poor to only grow larger.

There's one last thing that I'd like to discuss. Many companies have two different kinds of stock related compensation plans for the majority of their employees. One is the kind of stock options that I've discussed so far (i.e., "non-qualified stock options"). The other is an employee stock purchase plan (ESPP). In an ESPP, an employee commits to having fixed amounts withheld from her salary over a fixed period of time. This allows the employee to purchase the stock at a discount. At maturity of the plan (which varies from company to company), the employee can sell all the stock she receives and pay tax on the gain as ordinary income. If, on the other hand, she holds onto the stock for at least a year and a day, then the gains can be taxed at the long-term capital gains rates.

There's really a lot to talk about when it comes to options. It's a subject that I plan to visit again from some different angles in future columns as well.

One last thing to do before closing tonight's report... I'm going to second last night's nomination by Matt of American Express (NYSE: AXP) for this month's $500 purchase. I agree with many of the reasons Matt gave in support of his selection of our financial powerhouse. I'd also like to add that I'm quite pleased with the steps that our company's management has been making to take advantage of the tremendous possibilities offered by the Internet. These include its online brokerage, online banking, and business-to-business e-commerce initiatives. I'm happy with the company's financial performance as well.

Phil (TMFGrape on the boards)

Related Links:

  • Optionmania!: Part 1
  • Part 2
  • Part 3