FOOL ON THE HILL
eBay's Costly Stock Options

We're coming out of a period when employee stock options were issued aggressively by many and abusively by some. This is a direct result of the perverse incentives created by not properly expensing stock options. Stock option expensing reform is coming, but there's no need to wait for companies to formally expense options to see its impact. Proactive investors can look up a company's options grants and assess how this impacts the stock's value. eBay is a good example.

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By Matt Richey (TMF Matt)
July 19, 2002

This week's move by Coca-Cola (NYSE: KO) to voluntarily expense stock options was a huge victory for the integrity of the U.S. stock market. Our markets desperately need the transparency and comparability that will result when all companies properly account for options in their profit and loss statement. But Fools shouldn't wait for companies to expense options to find out how much dilution will result. Otherwise, options can silently but surely rob your future returns.

I'm willing to bet the average Joe Investor hasn't a clue what an enormous impact employee stock options can have on the value of a stock. I recently crunched the numbers for eBay (Nasdaq: EBAY) and found that dilution from options yielded a fair value estimate 25-30% lower than what would've resulted without the impact of options. (More on that later.) That's no small chunk of change. I believe once you understand the long-term dilutive impact options can cause, you'll totally change your perception of the value of companies that are dependent upon options.

How to find options info
Dilution from options easily eludes most investors, because the quantity of options issued is fairly well hidden in a company's proxies. The proxy statement, codenamed DEF-14A (for the sake of confusion, I think), can sometimes reveal significant clues about whether management is acting in the best interest of shareholders. This SEC-required document is filed once a year, about the same time as the 10-K annual report. In the proxy, you'll find managers' professional backgrounds, compensation (including options grants), inside ownership, and more.

Turning to eBay again and its most recent proxy, you'll find on page 22 that eBay issued 750,000 options to CEO Meg Whitman in 2001. Most proxies have a table like the one eBay provides. The table with options information typically comes after the table providing cash compensation data. Once you know what the options info table looks like, you can usually find it with a quick scroll through the proxy.

eBay's options information table notes that Whitman's 750,000 options represented 3.9% of the total options granted to eBay employees during 2001. To find the total options granted, we simply divide 750,000 by 0.039, which equals 19.2 million. Yes, it usually requires this esoteric calculation to get the total number of options. Again, just take any executive's options and divide that number by the percentage of the total, and you'll get a ballpark estimate of the total options issued for the year. (See, I told you option grants are pretty well hidden.)

In the case of eBay, we get a bit more clarity in the footnotes below the options table. Note 2 states that the total number of options issued to employees was actually 19.4 million, plus another 150,000 issued to directors. So the actual total was around 19.55 million. Not all companies provide an exact number like this, so more often than not, you'll have to rely upon the calculation I presented in the paragraph above.

Assessing a company's options grant
eBay issued 19.55 million options last year -- what does that mean? The way I gauge options is to compare them to the total number of diluted shares outstanding during the year options were issued. So for eBay, we take 19.55 million divided by 280.595 million diluted shares, as of the end of 2001. The result, 0.0697, tells us that eBay's 2001 options represented just shy of 7% of total shares outstanding. That's a huge number. At that rate, eBay could dilute shareholders' interests by 40% in just five years.

Keep in mind, of course, that options typically vest over multiple years (four is common), and options only become dilutive if the stock rises above the exercise price. As a result, not every option issued actually becomes dilutive. But with a great company like eBay that has a generally upward stock price, it's reasonable to think that at least half of its options over time will become dilutive.

To put eBay's 7% level of options into context, here are some options percentages from a handful of other well-known companies:

               FY '01     Diluted
Company        Options    Shares    Percentage
Yahoo!           59.9M     569.7M        10.5%
Cisco           297.9M    7196.0M         4.1%
Microsoft       223.0M    5574.0M         4.0%
Krispy Kreme      2.2M      58.4M         3.8%
Starbucks         9.5M     394.3M         2.4%
Coca-Cola        45.0M    2487.0M         1.8%
GE               60.8M    9932.2M         0.6%

Measuring the impact
Incidentally, I'm in no way implying that options are immoral. They're a perfectly valid compensation tool. But options need to be taken into careful consideration when assessing the value of a company. To the degree a company relies upon options, you should afford it a lower multiple to earnings (or sales, or free cash flow, or whatever). How much lower a multiple -- well, that's a tough question.

I attempted to tackle this question by valuing eBay with a discounted cash flow spreadsheet in which I included an annual dilution factor. I started with base free cash flow (FCF) of $140 million (not including option tax benefits), which is my rough estimate for 2002. I then assumed growth of free cash flow over three stages -- years 1-5, years 6-10, and years 11-20. At year 20, I assumed a P/FCF multiple of 30, which I think is reasonable for a monopoly-type company like eBay. Holding these assumptions constant, I changed the dilution variable and was able to see the resulting impact on eBay's fair value. The outcomes were striking.

In my test, I used two sets of dilution assumptions -- low dilution and high dilution -- and then compared the resulting fair value of eBay to what would result if there were no dilution at all. By the way, my dilution assumptions are just guesses, but they're shaped by the fact that over the last three years, eBay issued options equal to 7% of shares in 2001, 4.1% of shares in 2000, and 4.5% of shares in 1999. Here are the results:

              Level of Dilution
Years        None    Low    High
1-5            0%    2.5%   3.0%
6-10           0%    2.0%   2.5%
11-20          0%    1.5%   2.0%
Fair Value    $53     $40    $37

Constants:
-Base FCF estimate for 2002 = $140 million
-Discount Rate = 11%
-Growth Years 1-5 = 25%
-Growth Years 6-10 = 15%
-Growth Years 11-20 = 10%
-P/FCF at Year 20 = 30x

By the way, I don't mean to pick on eBay. eBay is a tremendous company, with practically an ideal business model. And to eBay's credit, CEO Meg Whitman yesterday mentioned that the company would be willing to expense stock options "as long as a fair and standard method of valuing the options could be applied," according to CBS MarketWatch.

Conclusion
What does all this mean? Let's set aside the issue that eBay looks richly priced at its current $58. I want to focus on the huge difference in valuation that results when you take dilution into account. Even with my "low dilution" assumptions, eBay's resulting value at $40 is 25% below the fair value estimate of $53 without any dilution.

Now, you may be thinking that this type of discounted cash flow analysis is too complicated to be useful, but I think this exercise leads us to a handy rule of thumb: For companies with annual options grants of 4% or higher, it makes sense to adjust the P/E or P/FCF ratio up by 25% to make it comparable to the valuation multiple of a company that's not massively diluting its shares each year.

And finally, there is a point at which a company's options almost represent robbery of shareholders. Check out Lesson 1 of our When to Sell: The Foolish Selling Strategy online seminar for more helpful advice. We hope after reading Lesson 1, you'll consider joining us for this eight-week, email-based seminar.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he had no position in any of the companies mentioned in this article. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.