FOOL ON THE HILL
The Danger of Stock Option Grants

Stock options are a great idea run amok, as evidenced by the massive option packages awarded to some high-profile CEOs. Options are given tax treatment so companies have an incentive to depend on them for more of their employee compensation. But options are not free to current investors, as they dilute present and current earnings per share. Bill Mann offers a shorthand he learned from Warren Buffett as a rough instrument to calculate their true cost.

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By Bill Mann (TMF Otter)
June 20, 2001

While there have been rumblings about companies' abuses of issuing stock options to employees, there has unfortunately been little popular response from stockholders. This is in part due to lack of a widely accepted means of valuing stock options when considering companies for investment.

Without this common language, agreeing on what constitutes a generous program and what constitutes an abusive one becomes problematic. But because employee stock options are not expensed, casual shareholders may remain blissfully ignorant of the cost to their long-term returns.

Corporate America's attraction to employee stock options came on the heels of the 1973 Employee Retirement Income Security Act, which created tax incentives for companies to set up employee stock option plans. The real kicker, however, came with the special tax treatment of stock options, which allows companies to defer taxation on compensation based upon options. While compensation comprised of cash or stock is taxed at market value, stock options are assumed to have zero value at issuance -- so the employee pays no tax and the company records no expense until the options are exercised.

But are stock options really worth nothing when they are issued? If so, then why are they such a significant component of compensation? Or, as Warren Buffett said in 1998: "If options aren't a form of compensation, what are they? 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?"

Indeed. This is an interesting dichotomy of logic: Companies can calculate depreciation schedules for the value of assets based on their expected useful life, but they are incapable of putting together an appreciation schedule for stock options. I find this argument difficult to accept. And as companies have depended more and more on options for executive compensation, it is a ticking time bomb. Buffett's company, Berkshire Hathaway (NYSE: BRK.A), has solved its own stock option dilemma by not offering any. The company awards bonuses to its 112,000 employees in cash, which shows up directly on the balance sheet.

When Apple Computer (Nasdaq: AAPL) CEO Steve Jobs can be awarded a single-year options package worth $872 million, it is time investors become more aware of the risk overly generous options programs can present to their portfolios. Far from me to say the CEOs of public companies should not be highly compensated, but there is a test of reasonableness Jobs' award fails miserably.

I'm also not opposed to options programs per se, but the combination of ignoring the cost of such programs and the potential detriment to outside shareholders demands that we, as minority investors, watch closely. As Sequoia Fund's Jon Brandt pointed out at its most recent shareholder meeting: "If [companies] issue 5% or 6% of their shares annually to employees as options, what they report to shareholders bears no resemblance whatsoever to the outside shareholders' actual share of the earnings."

Back to Warren Buffett, who, for someone who does not use options, has a great deal to say on the subject. When asked by a shareholder how he values stock options when analyzing the fair value for a company, Buffett replied that as a shorthand he uses the following formula to calculate the present value (PV) of its option grants:

PV = (number of options X exercise price)/3

By dividing by three, he is taking into account the present value of options that are granted for shares 10 years down the road, a rough average of forfeited options (by those who leave the employ of the company), and other factors. He then takes this number and subtracts it from the company's net income.

I have criticized Brocade's (Nasdaq: BRCD) options program in the past, so let's use them as an example. In fiscal year 2000, Brocade issued 30,775,00 employee options at an average strike price of $47.78. For those of you playing the home game, this means that with Brocade's basic share count at 207 million, the company gave its employees more than 14.8% of the company in a single year. This goes on top of the 14 million that carried over from earlier years. Nearly 45 million shares, 21% of the company, has been awarded to employees.

Let's look at the effect of these options on this year's net earnings. Brocade had net earnings in 2000 of $67 million. But if a rough value of these options were subtracted, we'd find a much rougher situation. If we use Buffett's formula, we find that the cost of the options awarded in 2000 is $490 million, meaning Brocade's options adjusted performance would have been -$423 million dollars.

That's a damn sight worse. Even though Brocade is a strong player in a growing market, I would never, EVER invest money into a company that treats its outside shareholders in such a cavalier fashion. The fact that options are not expensed is, frankly, ludicrous -- and it is enabled by all of us. Fortune's Justin Fox wrote a wonderful description of this in the magazine's current issue, where he used the substance abuser's mantra: "Step one to recovery: Admit that options aren't free." Bingo.

Fool community member RoughlyRight recently made the best post I've seen on this subject, including the rough cost of options programs to shareholders of some of the most well-known companies. His post was the catalyst that set me down this line of thinking, and interested investors should check it out.

Options programs are important attractors of talent, particularly in the companies defined by heavy intellectual property. Those who create should be compensated, and well. But where an options program veers into the realm of "kleptocracy" (like Brocade's) or oligarchy (like Apple's) investors need to set their feet down. When a company sets aside more than a percent or two of its "float" -- the total number of outstanding shares on the market -- in options annually, rest assured that the income reported in its financials is far from that which is actually available to shareholders.

Where there is potential for abuse, investors should be particularly watchful. It's like my friend Tom Hopkins said the other day: "Seeing as we're in flood conditions, maybe taking Bog Road isn't such a good idea."

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann assigns great meaning to "perfect moments." This morning he had one: coloring with his daughter, dog at his feet, Cannonball Adderley on the stereo, coffee in hand. At the time of this writing, Bill held shares in Berkshire Hathaway. The Motley Fool is investors writing for investors.