Price on Value
December, 1998

How would you like to have a product that is worth thousands, even millions, of dollars to anyone you gave it to but which costs you nothing? What would you do? Most people would find it very tempting to give away this bounty with little restriction. Of course, most likely you would not give such an idea a second thought quickly relegating it to the same pigeon hole as the goose that laid golden eggs.

Nevertheless, many managers of major public companies argue strongly that they do have such products—they call them options. And, as you would suspect, they love giving them to themselves and to their employees because they can do so without declaring them as an expense in their accounts.

An option, more specifically, a European call option, gives its holder the right, but not the obligation, to buy one share at a specified price, called the strike price, at a specified time in the future. If the strike price is equal to the current price of the stock, the option is said to be at the money. For example, if the current price of Microsoft is $100, then an at-the-money 10-year option would give the holder the right to buy one share of Microsoft for $100 in 10 years. If at that time, the price of Microsoft is $100 or more, the option holder receives the difference between that price and $100. If the price of Microsoft is $100 or less, the option expires worthless.

In recent years, options have been granted to managers and employees in massive numbers. For example, last year Microsoft granted 69 million options bringing the total of granted options to 446 million which represents approximately 18% of all stock.

There’s nothing new about corporations using their creativity to come up with ways to reward and motivate management and employees with everything from pen sets to Bahaman cruises, from cash bonuses to share packages. But why this recent rush into huge numbers of options?

One reason given by corporations is that the granting of options promotes success "by aligning employee financial interests with long-term stockholder value." (Microsoft 1998 Notice, page 6). The best I can say about this is that it is half true. If the stock goes up, everyone wins; if it goes down, only the shareholders lose. Hardly what most people would call an alignment. Another reason often given is that options "aid in the retention of employees" (Intel 1998).

Even if this alignment claim was true, given the massive increase in the number of options being granted, it is clear that there is some deeper reason for this avalanche of options. Here it is—when management hand out their largesse in the form of at-the-money options, they do not declare them as an expense! This is despite the case that anyone who receives a package of such options could immediately sell them to any major bank or financial institution.

Using the EURO function in the Valuesoft Investment System, an at-the-money 10-year Microsoft option would have a market price of approximately $63. (This assumes that the current price of Microsoft is $100 and that the volatility is 50%.) This is the amount, for example, that Microsoft would have to pay if they decided they wanted to buy such an option, or buy back the ones they issued.

Why don’t they declare them as an expense? The simple reason is that there are no Generally Accepted Accounting Principles (GAAP) requiring them to. Quite the opposite, companies follow APB Opinion No 25 (Accounting Principles Board) which states that at-the-money options are not an expense in the calculation of earnings. (Companies do, however, report them as an expense in the Notes to the financial statements.)

Warren Buffett wrote, "If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?"

The catch for shareholders is that these options are most likely going to appear as an expense when the options are exercised. For example, allowing for splits, assuming that Microsoft stock doubles every five years, a 10-year at-the-money option would be worth $300 = (4 ´ 100 – 300) in ten years.

So where does it leave a careful investor who wants to avoid any unpleasant surprises down the road? The answer is that you need to read carefully the notes to the financial statements in company reports and not just rely on the first numbers you come across or the numbers published by your favorite web site. With careful scrutiny, you generally find that there are actually four different earnings per share (EPS) figures. Two of these are in the main body of the report and two are in the Notes to the report.

In the case of Microsoft, these range from a high of $1.83 (regular basic EPS) to a low of $1.47 (pro forma diluted EPS), a range of $0.36. In next month’s article, I will describe how these figures are calculated. But for now, I recommend that if you are analyzing a stock, search for these four figures and base your decisions on the lowest one. Unless you do this, you will likely be making a gross over-estimate of their earnings per share and a corresponding underestimate of their P/E ratio.

Next month I will continue this topic and describe how the different EPS figures are calculated. I will also describe the strategies used by those holding large numbers of these options to cash in on this bounty and the pressures they create to make decisions not in the best interests of the company or the shareholders. Click here for Part II.