I hate to beat a dead horse on the issue of expensing stock options -- a topic I've written about in four previous columns: "Coalition of the Greedy," "The Stock Option Travesty," "Stock Options' Perverse Incentives," and "Rebutting Stock Option Defenders" -- but I feel compelled to weigh in again for two reasons. First, defenders of the status quo have recently offered yet another last-ditch legislative attempt to keep the stock option gravy train rolling, which Bill Mann skewered in a recent column.
Second, I've recently come across some new and insightful arguments that I wanted to share. In particular, I highly recommend reading "Stock Options and the Lying Liars Who Don't Want to ExpenseThem" by Cliff Asness of AQR Capital Management (click "PDF" in the left column to read it). In his essay, Asness addresses 11 arguments against expensing options and persuasively shreds each one of them -- often in a hilarious way.
For example, countering the argument that options shouldn't be expensed because they're difficult to value, Asness writes:
There is only one nonnegative option value that we know is demonstrably false -- that is, zero. Saying we cannot calculate option values accurately so let us choose the one and only value we know for a fact cannot be correct is simply nuts.. If option values really are much too difficult to calculate accurately except within wildly variable bands, then options should not be used at all for compensation. Is it prudent to pay people with a currency whose value we cannot even estimate? Is the best argument of tech executives against expensing really, 'We have literally no idea and cannot even begin to estimate how much of shareholder wealth we are giving ourselves, so therefore, we can issue as much of the company to ourselves as we want?'
Or what about the argument that expensing options will hurt the little guy? As one of my readers, a Cisco (NASDAQ:CSCO) employee, wrote to me after my last column on this topic: "Front line employees are the ones who will be hurt by this, not the CEOs. We will get less stocks or worst case no stocks. That equates to less opportunity for financial security, not greed. There are no pensions in high tech." Asness responds:
If helping the 'little guy' employee is the noble goal behind not expensing options, one does not have to sing the 'Internationale' to marvel that a major ironic consequence of this grand humanitarian gesture is to incredibly enrich a handful of managers.... It is also interesting that the real little guy -- the investor buying one share of a networking or semiconductor giant because he forgot to read the footnotes containing the real expenses -- is forgotten in this pious, pandering, pretend proletarian argument made by tech titans. Perhaps this realization is the reason tech investors lately have shown an annoying habit of voting to expense options and promptly being ignored by management. Still, simply put, whom the action helps or hurts does not change the fact of whether something is or is not an expense.... Let's separate socialism from accurate accounting.
One argument that Asness does not really address head-on, however -- perhaps because it's so silly -- is that if companies are required to expense options, there will be less innovation and our companies will become less competitive in the world marketplace, costing the U.S. jobs. For example, Intel (NASDAQ:INTC) CEO Craig Barrett argued:
And yes, we do raise the jobs issue as part of the debate. The Chinese Communists are promoting the use of options, and not for competitors of Coke or other companies who expense options but whose options are typically given to only the top few employees, but for high-tech companies like Intel and Cisco. You can ignore this aspect if you choose, but I doubt those who do have run a company in high tech and competed with the rest of the world.
Setting aside the hysterical Red-baiting, is Barrett's argument plausible? I think not. In fact, there are significant economic reasons for appropriate and consistent accounting policies, so I think that not expensing stock options actually harms U.S. competitiveness because it leads to suboptimal allocation of capital and labor. (I credit a friend, who wishes to remain anonymous, for these arguments, which I had not encountered previously.)
Proper capital allocation
A critical element of long-term U.S. economic competitiveness is a stock market that efficiently allocates capital, rewarding companies that are highly capital productive with plenty of it, and those that are not with little or no additional capital.
However, not expensing options creates an artificially rosy picture of high-options-issuing companies by inflating earnings, free cash flow, return on equity, and so forth. This in turn leads to more capital flowing to these companies than would otherwise be the case, at the expense of low-options-issuing companies (capital really is finite, though these days there seems to be a lot of it flying around). At the end of the day, this type of distortion can't be good for this country over time, as some companies get more capital than they should, and other, more deserving companies get less.
Proper human resource allocation
Perhaps even more important for U.S. economic competitiveness is the efficient allocation of our most precious asset: human talent. In this area, as with capital, not expensing options leads to serious distortions. Let's look at Boeing (NYSE:BA), which issues relatively few options (and, to its credit, has been expensing them since 1998), and Cisco, which issues mountains of options (and, to its discredit, is leading the fight against expensing them). Both companies are highly successful and provide thousands of high-paying American jobs. I would argue that our country is best served if the most talented managers are attracted in roughly equal numbers to both companies (and ones like them).
Is this the case? It's impossible to know for sure -- how does one measure management talent? -- but let me suggest that one indicator might be the number of Harvard MBA graduates at each company (full disclosure: I'm an alum, so I know I'll catch a lot of flak for even suggesting this, but consider that HBS alumni currently comprise about 20 percent of the top three executive positions of Fortune 500 companies and are CEOs of 57 of the Forbes 500 companies; the next closest schools are Wharton and Stanford, with 15 CEOs each).
My research on the HBS alumni website reveals that of Cisco's 34,000 employees, 25 received their MBAs at Harvard, or 0.74 per thousand. Of Boeing's 157,000 employees, only eight received their MBAs at Harvard, or 0.05 per thousand (and I would bet my last dollar that all of the leading business schools would show a similar trend). Of course Boeing does more of its own manufacturing and assembling, jobs that MBAs are unlikely to hold, but even if we were to look at senior management, there's little doubt in my mind that a disproportionate number of the best-trained managers in this country are going to companies like Cisco rather than companies like Boeing.
Why is this? Unquestionably it has to do with exciting technology, growth of the Internet, and many other factors, but I can tell you that, based on many anecdotes (plus some common sense), a big lure is the huge options package that Cisco and its ilk offer, giving employees -- especially senior managers -- the opportunity to hit the jackpot.
The result has been a huge flight of human talent to options-intensive companies, at the direct expense of non-options-intensive companies. You should have seen the shameless scramble of top business school students in the late 1990s, seeking their fortune in Silicon Valley -- it was so bad that many so-called "old economy" companies simply stopped recruiting at business schools. Was it really good for this country to have so many talented (albeit naive) people flocking to ridiculous, soon-to-go-bankrupt Internet companies?
There's nothing wrong with employees benefiting when a company and its stock are successful -- in fact, I applaud it -- but why should a high-options-issuing company like Cisco have an advantage in recruiting human talent vs. a low-options-issuing company like Boeing, simply because it is more willing to exploit an accounting loophole around options? It shouldn't, of course, and this inefficient allocation of human talent is, I believe, a long-term drain on our economy.
Conclusion
I'll let Asness have the last word:
There are legitimate arguments and difficult issues related to how to go about expensing options. Which formulas or methods to use and how often to update the values are points for debate. There are no credible arguments, however, for ignoring these expenses and thus intentionally overstating the earnings and understating the P/Es of not only companies with large options programs but also the market in general.
Seldom do we have a bright line dividing right and wrong in an area as nuanced as financial accounting. This issue presents one of those rare cases. Options unambiguously should be expensed. If expensing options is ultimately not required, we will have knowingly chosen a falsehood over truth and done so in the most callously public fashion -- after much debate, hand wringing, and lobbying. That would be bad. Options are the canary in our coal mine. If the canary dies, watch out.
Whitney Tilson is a longtime guest columnist for The Motley Fool. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. He did not own shares in any of the companies mentioned in this article at press time, though positions may change at any time. Mr. Tilson appreciates your feedback. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com. The Motley Fool is investors writing for investors.
