The Best Stock Options Model

As the Financial Accounting Standards Board (FASB) prepares to release its new proposal to expense stock options, I have some suggestions for what would be a perfect model.

You begin with a crystal ball, able to see future stock prices, so it becomes very easy to value options at their grant date...

You get the idea. The perfect model doesn't exist. But the one we have now falls substantially short of adequate in its disclosure of information to shareholders about the impact of stock option grants on their investments.

FASB's got a big fight on its hands, again. A decade ago, FASB proposed that stock options should be expensed on public companies' income statements. They got some key support from Warren Buffett at Berkshire Hathaway (NYSE: BRK.A  ) , who famously said: "If options aren't a form of compensation, what are they? And if compensation isn't an expense, what is it? And if expenses shouldn't go into the calculation of earnings, where in the world should they go?" They also had support from Carl Levin, Democratic senator from Michigan. And that was about it. The rest of Washington, it seems, was unprepared to see the difference between an expense and the measurement of an expense.

Maggie Mahar's new book, Bull! A History of the Boom, contains an entertaining and blistering section on the arguments going on in Congress at the time. The person who comes off most poorly is likely Barbara Boxer (D-CA), of whose arguments Mahar described acidly: "In that moment, Boxer demonstrated why Congress should not be responsible for setting accounting rules. First, politicians are not mathematicians; they have neither the training nor the inclination to delve into the details of corporate accounting. Secondly, senators and congressmen are elected to represent the financial interests and social goals of their particular states -- goals that, however admirable, have little to do with clean accounting."

(Note: Please go pick up this book. Mahar's description and analysis of the elements that fed into the stock market boom and crash is unbelievably prescient.)

Levin and FASB lost in spectacular fashion, and for the better part of the decade, only two companies in the Standard & Poor's 500 -- Boeing (NYSE: BA  ) and A&P (NYSE: GAP  ) -- elected to follow "best accounting practices" and expense their employee options. The remainder of the companies either didn't grant them or treated them as if they were free on the income statement.

But stock options are not free. That's one of the favorite myths of expensing opponents. Let's address a few of these, then I'll discuss what I think is an appropriate treatment of stock options.

Myth 1: Stock options are non-cash expenses.
While the actual transaction may require no cash, there should be no doubt that the existence of options means that there is a non-zero chance of economic benefit being transferred from existing shareholders to employees. A recent Merrill Lynch (NYSE: MER  ) survey notes that in 2000, 62% of Lexmark's (NYSE: LXK  ) free cash flow would have had to be diverted to neutralize options dilution, 151% of EMC's (NYSE: EMC  ) , and 89% of Dell's (Nasdaq: DELL  ) .

In fact, Merrill's survey found that among 11 of the largest technology companies, 0% of their free cash flow would have been for the benefit of non-employee shareholders after the value of dilutive shares was subtracted. Think 2000 was exceptional? Maybe, but in the misery of 2002, the amount of free cash that would have been necessary to offset options was still 12%. And as Merrill notes, since 2003 was such a hot year for the stock market, we can expect that the amounts of free cash needed to offset will be closer to 2000's than to 2002's.

Besides, myriad other forms of compensation that do not require cash are expensed. As are, interestingly, stock options that are granted for every other use besides employee compensation. Further, this argument ignores the fact that stock options sold on the open market instead could generate cash for the company -- cash foregone from other sources.

Myth 2: Expensing options will be a drain on the economy and hurt job creation.
Utterly, laughably false. FASB's rules do not restrict in any way the ability of companies to grant options. Nor does it create any additional economic expense. There is no additional economic burden placed on any company in America due to the need to expense the options. Certainly, some options-abusing companies are not going to like how their earnings reports look, but again, the change in how information is reported does not change the underlying economics.

Are options worth zero? If that were the case, they would be lousy incentives in the first place. If options actually increase shareholder value, they can and should be given. I quote a 1994 letter to the SEC from Paul Miller, author of Quality Financial Reporting: "There is no valid defense for keeping truth from individuals and the capital markets when the truth is known or knowable. Thus, a decision against recognizing compensation costs to 'protect' someone's interest (even the national interest) is not defensible."

Myth 3: Options cost is already reflected by the diluted EPS.
This means that a company must only count its options that are in-the-money against earnings. This ignores one of the key reasons options are coveted at all: time value. For example, 100,000 stock options granted at $5.01, good for 10 years, have some value to the grantee, even if the stock price at the moment happens to be $5. Does anyone actually believe that they are worthless at $5? If you do, and you own such options, please call me -- I'd love all the one-cent-out-of-the-money options you care to give me. I'll even pay a dollar for them.

Myth 4: Since we can't be exact with options expense, zero is the better number.
Warren Buffett notes that companies don't know how long a 747 will last, but they know precisely the accounting rules by which they are depreciated. The only reason zero would be a better number than some value that is conservatively derived would be that if the options are actually worth zero the day they are granted. If that were the case, we wouldn't be having this conversation. Most accounts in a financial statement require estimates -- even revenues. The error in measurement of stock option value is not likely to be larger than the error of not measuring it at all.

And here's something that ought to land home with companies that are resisting expensing: According to that same Merrill Lynch report, most institutional technology investors they surveyed made their own adjustments to earnings to account for options. What are the odds that these investors are making adjustments that are larger than the ones that would be made under an expensing regime? For example, I expense options at 100% of their value, assuming the worst-case scenario. If they believe that there is a long-term gain to be had by fighting for an imperfect information flow, their own investors are telling them this is not the case.

Better treatment
All that said, what would I suggest for proper treatment of options? Let me throw out some, ahem, options on options that would far improve the less-than-ideal treatment at this point.

1. Stock options are derivative instruments with some level of risk for both the grantor and the grantee. All other forms of derivatives have an accounting treatment on the balance sheet, employee stock options have none. It would be far more instructive to know what the derivative liability would be in a mark-to-market entry on the liability ***account*** with corresponding credits. In this way, investors can see the contingent potential exposure to options that at present actually exists as a form of off-balance sheet financing. Companies extend to employees the opportunity to purchase shares at a price -- a form of liability for the company since it cannot renege on this obligation. All adjustments would trigger credits or debits from the income statement.

2. Cash flow from operations is distorted by options treatment. Companies take a tax credit for exercised options -- equaling the majority of eBay's (Nasdaq: EBAY  ) cash flows, for example -- in cash from operations, but relegate cash outlays to repurchase shares to offset dilution into cash flows from financing. Compensation is clearly an operational component, and cash used to repurchase shares to offset dilution should be reclassified as such on the cash flow statement.

3. Companies should be forced to restate past earnings if they reprice options, or make supplemental grants. These actions (along with serial grants) put the lie to the contention that options align employee interests with shareholders. One need only take a look at Juniper (Nasdaq: JNPR  ) , which sits at about 10% of its peak value. The company elected to reprice employee stock options near the bottom of the market, bringing the average strike price on its 70 million-plus options to less than $11 per share. At this point, the intrinsic value of those options equates to about 80% of all shareholder equity, and while the deal may have been great for employees, it doesn't do a bit of good to a shareholder who bought at $200.

Under present rules, companies that reprice their options have to take an expense against earnings. Since this generally happens when times are terrible anyway, this expense just gets thrown into the big bath of losses. Wouldn't it be more accurate to make the company match those recognized expenses with the periods that the work was actually incurred? Otherwise, they're just understating compensation costs in several quarters, then overstating them in one.

I leave with one thought. Those who seek to block FASB from doing its job of determining accounting standards, in this case, have stated that expensing puts employee ownership of stock at risk. It would be a pity if that were the case, for employees motivated by their ownership in companies cannot help but be a positive thing. But a change in accounting only puts this at risk if the choices made while the expense isn't recognized are sub-optimal. ***While I may suggest a different model than FASB ultimately adopts, let me be clear: anything FASB does on this is better than the existing approach, and anything Congress does to stand in the way is nothing but thuggery. FASB's interest is to optimize information flow. Congressional machinations to limit this flow are ultimately a cost to all of us for the benefit of the few. That's wrong.***

We're not talking about a change in economics, but rather a change in information flow. Where Congress is seeking to restrict information flow for the benefit of few flies in the face of what a non-political entity like FASB is chartered to do in the first place.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann is a member of the User's Advisory Council for the Financial Accounting Standards Board. He holds shares of Berkshire Hathaway, one of the most shareholder-friendly companies ever devised. For a full list of Bill's holdings, consult his profile. The Motley Fool is investors writing for investors.


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