[This article was edited on Feb. 27, 2003 to change the source for a company's options grants from the proxy statement to the annual report Form 10-K and to change the related explanation.]

Would you buy a mutual fund with an annual expense ratio of 3%, 5%, or even 24.3%? Never! All else being equal, you would choose a low-expense broad market index fund, almost certainly with expenses below 1%.

Yet individual investors, now sophisticated enough to stay away from high-expense funds, buy stocks without paying attention to the "fees" charged by management. Every year, many companies charge you by giving away a percentage of shareholders' ownership to employees in the form of stock options. It's no better than mutual fund expenses, and can be a whole lot worse. Why do they do it, and why is it bad?

The stock option giveaway
Here's how it works, made easy. Let's take Jack Horner Pies (Ticker: THUMB). You own one of its four shares of stock. Think of the company as one of its own scrumptious coconut cream pies cut into four pieces, representing the four shares of stock. The company grants another share to the CEO (or any employee) in the form of a stock option. Assume that the CEO exercises her option to purchase the share. Whether she holds the share or sells it, there are now five shares outstanding -- the same pie is now cut into five parts. As your precocious child will tell you, your share is worth 20% less. And nobody asked you.

But Jack Horner is having a good year. It increases its earnings, or our preferred measure -- free cash flow -- a sweet 25%. You like that, because your share of business ownership is worth more. Problem is, your relative ownership share is now only the size you started with before the company granted a new share to the CEO.

Yup, the pie grows, but all things being equal and in a perfectly rational stock market, your piece is the same size. And if Horner Pies grew less than 25%, you would actually have a smaller piece. Using the mutual fund example, if a fund pays out 2.50% a year in expenses, then it must gain 2.50% in value just to keep its net asset value even. Same with your stock. That's one reason you must plug in annual share dilution
when measuring a company's current value based on future performance.

How do you know how much stock your company gives away each year? It seems you can simply look at the basic number (as opposed to diluted) shares outstanding on the income statement of the company's latest quarterly or annual report, and compare it to the prior year's total. But that doesn't work. When companies merge or spin off operations, their share count increases or decreases, and you don't want to spend your life combing the filings for these intricacies and their import. For example, shares issued to pay for acquisitions usually bring at least some value with them in the form of acquired company earnings, so they aren't pure dilution.

The change in absolute share count doesn't tell us about share buybacks, either, which we like when they're not funded through corporate debt. But even a decreasing or stable share count doesn't tell us the whole story. We must know the employee stock options (ESOs) percentage to be able to tell whether the buybacks benefit us or merely reduce or balance out the ESO grant. If the latter, the company ironically uses cash flow from the tax benefits of issuing ESOs to buy back your shares, and then gives them away at a discount to employees, starting the cycle over.

Yes, do this at home
To find out how your company stacks up, go to a source such as our Quotes & Data page, click SEC Filings, and find the latest annual report Form 10-K for your company. Try to find the stock option table that generally includes the last few years of options outstanding at the end of each year, the number granted, expired, and cancelled/forfeited/expired each year. You may use CTRL + F on your keyboard to bring up the search function. Type "stock options" to start, but you have to nose around a bit. Here's is an edited version of eBay's (Nasdaq: EBAY) table from its 2001 Form 10-K:

               Year Ended December 31,
             1999     2000     2001 (in thousands)
Outstanding  18,493   26,236   26,249
at beginning 
of period
Granted      12,210    9,037   19,621
Exercised    (3,551)  (4,499)  (6,813) 
Cancelled      (916)  (4,525)  (3,955) 
at end of 
period       26,236   26,249   35,102

What you find will also include a weighted average price for each entry and the number exercisable in a given year, but that's more than we need for our purposes.

For a given year, take the number granted and subtract the number cancelled, forfeited, or expired. That's your raw total of options dilution.  

Then go to the income statement in the same document. At the bottom, find the basic number of shares outstanding at the end of the prior year. Divide that number by the raw total of options dilution. Voil�! You have the percentage of your ownership the company gave away that year.

Example: In 2001, Little Jack Horner Pies' 10-K revealed it issued 300,000 ESOs to its employees, because they had been such good little boys and girls, while 100,000 expired (they were unexercised, employees left the company before their options granted had vested, or the company canceled some, perhaps to regrant them at a different price). The net dilution was then 200,000. Jack Horner Pies' Form 10-K income statement for fiscal 2001 showed 10 million basic shares outstanding at the end of the prior year, 2000. By adding 200,000 net new options to 10 million sharecount, the company diluted current owners by 2%.

Alert readers know that ESOs come with vesting periods and strike prices (the prices at which they may be exercised), and that they may not ever be exercised. Yet even if underwater (when the strike price is way above the current stock price), they represent a real threat to your potential for appreciation. They represent "overhead supply," stock that will come into the market if the stock moves up. And companies tend to reprice ESOs that are underwater for very long, increasing likely dilution.

Drama in real life
Perhaps the worst ESOs offender is CRM software maker Siebel Systems (Nasdaq: SEBL), the real-life 24.3% example that began today's sorry tale. Siebel granted 24.3% of outstanding shares as ESOs in 2001, after two years of double-digit grants. Meanwhile, the stock fell almost 50% in 2001 and another 80% so far this year, while revenues began dropping at double-digit rates in the Q3 2001. True, Siebel's business has been a real success, growing free cash flow over the same 1999-2001 period, but it gave away shareholders' piece of that with options. No wonder the CFO recently announced steps to address the situation -- without massive repricing.

Are ESOs always bad? Perhaps the only plausible reason to look the other way while management gives away your ownership share is if the stock option grants are correlated with return to shareholders in the form of better business performance and higher stock price. If the stock appreciates 100%, you probably don't mind the ESOs, as long as the company diluted your ownership share through new ESO grants by a lot less than 100%.

Let's take two companies with large stock option programs: newer, fast-growing computer networking equipment maker Brocade Communications (Nasdaq: BRCD) and electronic game software maker Activision (Nasdaq: ATVI). Their numbers:

          Brocade Communications              
Year*     Stock  Revs.  FCF  % Options          
1999-date** 38%         
2001       -78%    56%     1%    22%
2000       238%   379%   120%    15%
1999       494%** 184%    N/A    12%

Year*     Stock  Revs.  FCF  % Options          
2000-date  204%
2002        84%    27%    44%     8%
2001       102%     8%    N/A    18%
2000        -3%    31%    N/A    11%

*Fiscal years
**From May 1999 IPO

For Brocade, your returns depend on when you bought, and the employee stock options grants cancel out the share price gains if you held since the close of the May 1999 IPO. But for Activision, even with hefty stock option grants, revenue growth and stock price appreciation have outpaced the option grant rate, and free cash flow has turned positive heftily.

But there's a reason I said "plausible." Even the best newer company's growth rate sooner or later calms down. As that rate slows, the share of options grants becomes more and more significant, biting off larger chunks of returns -- just like mutual fund expenses. When that happens, can investors trust management to slow down its voracious options appetite? I trust management that deserves trust by showing restraint today  -- while the sun is shining. Not just when it rains.

Bottom line: As a guide, you want established companies to grant no more than 3% a year of their basic shares outstanding in the form of stock options, and developing companies 5% or less. Next week, I'll look at our Rule Breaker Portfolio holdings and examine how they stack up against these guidelines.

Have a most Foolish week! Updated portfolio returns below. The Rule Breaker Portfolio handily beat the S&P 500 and Nasdaq for the month, but is still in between them for the year.

Tom Jacobs (TMF Tom9) refuses to spend much on clothes. It shows. At press time, he owned no shares in companies mentioned in this story. To see his stock holdings, view his profile. The Motley Fool has a disclosure policy.

Rule Breaker Portfolio Returns as of 9/30/02 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week      -1.46%**   -2.21%   --      -1.10%
Month     -6.99%**  -10.57%   --     -11.77%
Year     -31.92%**  -28.99%   --     -39.91%
using IRR*** since 8/4/94 +19.21% +7.31% +9.04% +6.15%

*Dividends added. Or, danger ahead. Whatever.

**Please keep in mind that these figures will be distorted for the RB Port for the short period around which we add any cash (see next note!). Since July 2001, we consider depositing $12,500 in new cash each quarter unless we have enough available for new investments without it. 

***Compound Annual Growth Rate using Internal Rate of Return. This performance measure is more meaningful than total return because we began adding cash occasionally in July 2001. In a total return calculation, or ((Current Value - All Cash Deposited)/All Cash Deposited), cash added would show up as returns. And that wouldn't be cricket!