Um, OK. Sly username, anyway.
I apologize for the Phaedrosity of my last post – board meetings make me wonky. Now where were we?
Flowbark you got it in one on how options exercise generates net cash for companies which do not settle them in cash for their employees (some do, which I forgot to mention). Nicely done – it’s a credit to you that you went out and looked up the facts.
As to the politics question – think about it for a second. Sure, the proposal on the table is to instruct the FASB to “think about it and take appropriate action.” But come on – Congress is proposing to drop a pretty big hint here, and the FASB knows what the “right” answer is to Congress.
OK, option valuation. Apart from (and a part of, I suppose) should options be expensed is how to do it. Normally, options are granted at or above the current price of the stock, so on the granting date there is no “intrinsic” value – the grantee can’t make any money by exercising them. But of course that doesn’t mean that they are without value. Four main ways to value options off the top of my head.
Assume a return and do the math. You see this in proxy statements. They have a chart which shows the future value of an options grant if the stock appreciates by 0%, 5% and 10% per year. It would be easy for the FASB simply to pick a number (say, the long-term return of the S&P 500 or an industry subset of the index), have companies discount the returns by a constant rate (say, the 3-month bill at the beginning of the grant year) and, as Emeril says, BANG. You’ve got a valuation.
Benefits: Comparable valuation metrics across companies, easy to understand in the first year.
Problems: There is something close to a zero chance that the stock will appreciate exactly as much as whatever number is chosen, making the day-one valuation wrong. If you revalue all outstanding options each year, it becomes a very tedious task, and all the moving parts of the various revaluations would kill the probative value of having the number flow through the earnings in the first place. Imagine a company having a credit to earnings because their stock fell 90% last year and all of last year’s options are now worth a lot less!
Pretend it’s an open-market option. The SEC likes this method a lot. Basically, you apply a Black-Scholes valuation to the option. Black-Scholes is an option-valuation methodology developed in the ‘70s which takes into account a stock’s price, volatility, time remaining on an option, the option premium and about a bajillion other things (dividends, the risk-free rate, etc.) into account. It was essentially a license to coin money in the options market until computing power caught up with math power, because it was such a good predictor – options always seemed to return to the Black-Scholes price if they deviated from it in the first place.
Benefits: It at least tries to approximate the value of the option out there in the marketplace.
Problems: One of the biggest assumptions of Black-Scholes is that the option is salable. Executive options, of course, are not. There are various tweaks to the formula that different compensation consultants use, but there’s no consensus – which means you could shop consultants to get the results you want. I suppose the FASB could mandate a method, but I’m not sure you solve much by doing that. Also, the valuation would not be useful for comparisons between companies, because the input varies so much from firm to firm. And of course there is the whole re-valuation problem above. Not to mention that it takes a PhD to understand it.
Use the cost of buying back the stock. This ties into the dilution we discussed. If a company issues options for 2 MM shares and has a 2 MM share buy-back program, it makes intuitive sense that the “cost” to the company is at least what it cost to get those shares into the treasury less the proceeds received from exercise.
Benefits: Easy to understand, actually matches up with the cash used by the company, which at the end of the day is the Holy Grail for cash-flow guys like me.
Problems: Most companies issue options for years before they buy back any shares – indeed, most of the companies in which I invest have strict limits set by their creditors on the amount of stock they can buy back. And of course, even for those companies which do buy back stock, there will be a timing mismatch from granting to buyback, which mismatch will often slop over the fiscal year-ends.
Value the options at exercise, not granting. Sounds simple and sensible, right? A company only really knows what an option is worth when it gets exercised – whatever the executive makes is, essentially, the opportunity cost lost to the company by selling shares at the exercise price instead of the current stock price. This is the deduction the company gets for tax purposes.
Benefits: Easy to understand, matches cash flow, at least in terms of lost opportunity.
Problems: Delays expensing of the option until years after it is granted, removing most probative value of doing it in the first place. Also, it takes the company’s earnings out of it’s own hands – indeed, the better a company does, the higher its stock will go, increasing the likelihood of taking a big loss related to exercises which might drive down the stock price, etc.
To sum up: This stuff ain’t simple, and the opportunities for unintended consequences are very high (indeed, it was Congress’ last “fix” of executive salaries that got us in this place to begin with). Congress, frankly, is too stupid and too short-sighted to have anything meaningful to say on the issue.
Should options be expensed? I dunno. Frankly, my job is easier if they’re not – I’m a creditor and my goals are simplicity of financial statements, close tracking of GAAP earnings to actual cash flow, and as few assumptions about the future as are necessary to get the job done. So I don’t like it. But apparently, too many investors weren’t reading the proxies or the footnotes to the financial statements (where all this stuff gets disclosed, right now as we speak). I happen to think that folks who don’t read that stuff deserve to lose money, but that’s just me. My solution would be simply to tell stock investors to use the “fully diluted” per-share figures, also published currently, and to get over their bad selves.
Please explain. (Is there a web site on any of this?)