The Billion-Dollar Secret

I've read articles on the evils of stock options -- how they're hard to value, how they provide misguided incentives to employees, and, most importantly, how they can deceive investors. But I've never gotten a firm handle on this last point. I need the numbers. I need to know where to find the numbers. And I need to know what to do with them. That's what this article is about.

Stock option accounting is a messy business. Like a snarled fishing line, the best way to untangle the mystery is to pick a loop and start pulling.

Exercised options
In this article, we'll focus on exercised options -- the easiest to understand, because the numbers we need show up as line items on a company's cash flow statement. Without delving into the basics of stock options, here is the accounting story.

Say Jack works for Company X. He decides to exercise 100 options with a strike price of $5 each. So Jack pays Company X $500 to exchange his options for 100 shares of stock. If the stock price is at $20, Jack can turn around and sell his stock for $2,000, recognizing a $1,500 gain. And this is where it gets dicey....

Evil No. 1: The accounting fiasco
When Company X pays Jack's salary, it records that as an expense. This reduces its operating (and pre-tax) income, and, accordingly, its taxes -- both the actual taxes paid to the IRS and the tax expense amount shown on its income statement. (Companies have two sets of books: one for the IRS on which actual taxes are based, and one used to calculate the tax figure shown to investors. Because of accounting conventions, these amounts often differ.)

In most cases, Jack pays taxes on the $1,500 as if he'd received the $1,500 in salary from Company X. But even though Company X doesn't have to report the $1,500 as an expense to investors, it is allowed to deduct $1,500 from its IRS-reported taxable income. The investor-targeted income statement shows neither the expense (the big issue), nor the proportionately lower tax (which would slightly offset the effect of that expense).

But on the statement of cash flows, which reconciles such accounting-vs.-cash discrepancies, things are different. Reconciliation of the tax benefit boosts a company's operating cash flow by up to approximately 35% (i.e., its tax rate) of the stock-price-minus-strike price spread (the spread was $1,500 in this example), depending on its tax rate and other tax circumstances. And the $500 Company X gets from Jack to buy his options shows up in its financing cash flow. (Confused? You wouldn't be if you'd clicked on that link. Go on, go back and check it out.)

Combined, these two line items could generate substantial "cash reconciliation" benefits for the company. In the big picture, these benefits are significant -- often enough to push negative total cash flow into positive territory. That's a powerful incentive for companies to issue more stock options -- regardless of their effect on existing shareholders.

There's more. Since Company X doesn't record the $1,500 as an expense, it isn't deducted from its income (as either it or an estimate of option value at grant time should be, because options are, in fact, compensation). A higher net income translates into better margins and stronger cash flow, all else equal. If those aren't accurate, our valuations won't be either unless we take corrective action. Let's take a look at how significant these tax advantages are in terms of free cash flow.

Evil No. 2: Dilution
Why should Company X have to report an expense on its income statement? It never actually paid Jack the money. Well, not directly, but it did give him something of value -- and something that also had the potential to dilute shareholders' value, for that matter. Let's take a look.

After Jack's exercise, there are 100 more shares owning the same enchilada. Obviously 100 shares is no big deal, but when we multiply this across many employees at a company, the numbers get pretty big. Let's look at the dilution effect for the same companies (share numbers are for the most recent fiscal year and are in millions):

Shares increasing by 1% may seem insignificant, but that's costing Intel shareholders roughly $1.5 billion per year in market cap dilution. And Cisco's 1.4% costs shareholders $1.7 billion per year. That's not chump change.

To offset dilution, many companies institute share buyback programs. But this doesn't square things with the investor. Let's revisit our example. In order to avoid dilution from Jack's exercised options, Company X must buy back 100 shares of its stock. If Company X pays the same $20 per share Jack did, this comes to $2,000. But Jack paid only $500 to buy his options, so Company X is out $1,500 (not coincidentally, this is the amount Jack makes on exercising his options). So in the event of a buyback, Jack's stock option exercise is, ignoring taxes, equivalent to the company's paying him $1,500.

Before we leave these charts behind, I want to underscore an important point. Young companies experiencing strong growth are especially affected by their stock option policies. In 2003, for example, Taser's stock price increased almost 2,200%. As a result, existing options became very valuable. Employees took advantage, exercising 735,000 options, resulting in 9% share dilution and $4 million in tax savings. When Taser added this $4 million into its operating cash flow, it was able to turn a $3.3 million free cash flow loss into a $700,000 free cash flow gain. Obviously, this has a significant impact on our valuation of Taser should we, like so many well-meaning investors, lack the time and expertise to make appropriate adjustments. Perhaps it's no wonder companies with aggressive option policies are fighting accounting reform.

How to find the numbers
All these numbers can be found inside a company's annual report/10-K. Once you've located it, turn to the statement of cash flows. At the top you'll generally find net income. The tax benefit from employee options occurs as a line item under "cash from operations," and cash received from exercised options shows up under "cash from financing activities." Sometimes, this latter number exists as a separate item, but more often it is included in "issuance of common stock." Companies can issue common stock for many reasons -- such as to make acquisitions or to raise cash for capital improvements. More often than not, however, the largest percentage of new issues goes to cover exercised stock options.

Finding the number of options exercised in a given year is trickier, and requires a journey into the footnotes. Use a search function (very easy in MS Word or Adobe Acrobat Reader) to find the word "exercised" or "options outstanding." The options table will tell you how many new options were granted, how many were canceled, and how many were exercised.

Similarly, you can find shares outstanding at the bottom of the income statement. This number usually comes in two flavors -- basic and diluted ("diluted" assumes exercise of "in the money" options).

Finally, I remind you that these numbers are only a part of the whole stock option picture. My next article will look at the effect of outstanding (non-exercised) options on a company's financials, and will examine an alternative accounting method that attempts to provide investors with more honest data. We will also look at a simplified model that helps estimate the numbers without the need for a supercomputer. By understanding these issues, we'll be able to analyze the company and its opportunities more accurately.

Fool contributor Jim Schoettler recently returned from the National Club Ultimate Championships in Florida, where his team lost the championship game by one point (he's accepting condolences via email). Jim doesn't own any of the stocks discussed in this article. The Motley Fool has a disclosure policy.