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Friday, May 7, 1999

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Optionmania III: Takedown

In columns last Friday and Wednesday, I discussed how options impact income statements, the impact of options expense on several companies, and the reason companies do not currently record options expense. Investors should be aware of numerous additional anomalies associated with options. Below are several questions and my answers.

Isn't options expense incorporated in the diluted earnings per share (EPS)?

NO! The difference between basic and diluted EPS only reflects the impact of the increased number of shares issued for options on earnings. It does not incorporate the expense of the options in net income.

Using the example from last Friday, New Age posted net income of $275,000 and diluted EPS of $2.74 on 100,400 shares. While the share count incorporates the impact of options, net income does not. If we assume that Sally's options are worth $10,000 (the amount of foregone salary relative to her Old Line offer), New Age would have posted net income of $265,000 (not $275,000). The company's EPS would have then been reduced to $2.64 since 100,400 effective shares would still be outstanding. Note that New Age's EPS figure would be a penny lower than Old Line's, which is similar in every way except it uses only cash compensation. This is because the number of New Age shares outstanding has increased, causing dilution. (For simplicity's sake, taxes are ignored in this example.)

If what you're saying is true, only the income statement would be impacted. The balance sheet and cash flow statements would still be accurate, right?

Not really. All three financial statements are intertwined and inaccuracies in one carry over to the other. In the same way that net income is overstated, cash flow is effectively overstated. The actual amount of cash isn't misstated, but the company has given away a cash-substitute (the option), which is not reflected on the cash flow statement. If the company were forced to pay its employees in cash, rather than with "self-published" options, operating cash flow would be lower.

The balance sheet is another issue. When stock options are exercised by employees, a company boosts its shareholder equity account by the amount of the exercise price. While this treatment accurately reflects the transaction as it occurs, it ignores the fact that the stock is actually worth more than the option price at the time of exercise. In effect, this understates the amount of equity capital invested in the business, distorting some productivity measures used by analysts (such as return on invested capital).

Are some company buyback programs related to stock option plans?

Quite often. Many companies engage in buyback programs to limit the dilution caused by stock option programs. These programs validate the theory that options costs are real.

Let's assume that a a company repurchases 1 million shares for $50 million, while employees exercise options on a similar number of shares at an average price of $30 each. From a basic shares perspective (which you should normally avoid since diluted shares is more representative, but it simplifies this example), the number of shares outstanding would remain the same -- 1 million shares were issued and 1 million shares were repurchased. The only difference is that the company has $20 million less cash because it spent $50 million repurchasing stock and only received $30 million for the stock sales. No part of this $20 million ever hits a company's income statement.

To see if a company is engaging in a stock repurchase to reduce shares outstanding or to offset option grants, look at the reported number of diluted shares. If the number of outstanding shares is not decreasing commensurately with the announced number of shares repurchased, repurchased shares are probably being used to offset option grants. In such a situation, it may be worthwhile to check out a company's annual report or 10-K to see the extent of its option grants.

Do options have any income tax impact for the company?

I'm not a tax expert and different stock option plans have different tax impacts. Some option plans do provide a company tax benefits while others do not. I do not have current information on what is deductible and what is not, but some plans do lead to significant tax benefits for companies.

Are stock options included in the government's Employment Cost Index (ECI)?

No. Many economists looking for signs of inflation have been closely tracking the ECI, which has recently indicated small wage increases for Americans. I was curious if this index incorporated any cost for employee stock options, which have become an integral portion of compensation at many companies. According to two people at the Bureau of Labor Statistics, the ECI does not incorporate options expense (although it is under consideration).

While the absolute level of stock option grants relative to total compensation is probably small, I would guess that many people are currently being granted increased options grants in lieu of raises. Determining whether options impact the ECI would be quite interesting.

What should investors do to incorporate the unrecorded cost of options?

That is up to each investor and the method used to evaluate stocks. If you believe valuation is an important factor in picking stocks, some adjustments should probably be made. Although the cost of option grants is currently ignored by most analysts and investors, I expect this will change at some point. The catalyst for this change will likely be regulatory (i.e., accounts require this expense to be recognized on the income statement) or societal (i.e., employees decide that cash is preferable to option grants). The latter scenario would force people to pay attention to the cost of options because cash compensation would jump up at many companies, decreasing earnings.

The most important adjustment to make when incorporating the impact of option grants is to net income. Unfortunately, most companies only provide information on this subject on an annual basis. (Kudos to Microsoft (Nasdaq: MSFT) for including this information quarterly on its website.) To get a thumbnail idea of the options impact on future earnings, I look at the percentage of options expense relative to the latest year's reported earnings and carry that percentage through published estimates.

For example, from their 10-Ks, I know options expense would have reduced 1998 earnings at T. Rowe Price (Nasdaq: TROW) and Starbucks (Nasdaq: SBUX) by 7% and 21%, respectively. The First Call consensus earnings estimate for these two companies are $1.63 and $0.60, respectively, in 1999. From an analytical perspective, I consider these figures to be $1.52 ($1.63*0.93) and $0.48 ($0.60*0.79). I think this "adjusted" net income should be used when calculating performance metrics like net margins and valuation measures such as the Price/Earnings (P/E) ratio. While the options expense included in the footnote of next year's annual report will probably show a different impact, I haven't found a better way to estimate the prospective cost of options.

Before closing out this series, let me point out that stock options are a very effective tool for companies to use in attracting and motivating employees. In addition, they provide a means for small, upstart companies with limited cash resources to attract superb recruits. My only beef is that they are not accounted for on the income statement, which leads to distorted financial reporting. Investors utilizing profitability and valuation measures in their decision-making process should not ignore this compensation expense.

Do you have an opinion or question on employee stock options? Can you think of a better way to incorporate this hidden expense in stock analysis? Come over to the Fool on the Hill message board to share your ideas.

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