John Price,  Ph.D.

It is becoming a daily occurrence to read press releases from companies of all sizes and types announcing that they will be buying back a portion of their own shares. Some recent headlines are "McGraw Hill CEO says buyback is a good bet," "J.P. Morgan board approves buyback up to $750m," "First Financial approves 5 per cent buyback," and "Thermo Electron authorizes buyback up to $100m." Normally you might take news like this as positive for two related reasons: the companies believe their shares are undervalued and are likely to rise, and the earnings per share EPS will increase because the pies are being cut into fewer pieces.

Microsoft has been at the forefront of this buyback trend and since 1990 has repurchased 341 million of its own shares, or about 14 per cent of the current number of outstanding shares. A good sign you say. Perhaps not, since in the same period 807 million shares were issued by the company under its employee stock option and purchase plans.

My quibble is not that equity in the form of stock and options is being passed over to directors, officers and employees. As an outsider, I can only trust that this is done fairly with the best interests of all parties fully in mind. My concern is that when this is done in the form of at-the-money options, the effect on earnings is not documented in the main part of their financial reports. Generally you have to hunt it out in what is referred to as the "accompanying notes."

In Part I of this article I said that 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.

Using the EURO function in my Valuesoft investment software, an at-the-money 10-year Microsoft option would have a market price of approximately $73.30. (This uses the Black-Scholes valuation model assuming that the current price of Microsoft is $130 and that the volatility is 35%.) This is the amount, for example, that Microsoft would have to pay if they decided they wanted to buy such an option. Or, more importantly as we shall soon see, the price you could expect if you had this option and put it on the market.

This price, however, is not declared as an expense against income in the main part of any financial reports. There you usually get two EPS ratios. In both cases the earnings figure does not include the expense of granted options. Consider Microsoft with declared earnings of $4,462m. In the first case, EPS is calculated with a denominator consisting of all outstanding shares, 2,432 million. In the second case, the denominator of 2,681 million includes the stock options issued by Microsoft. The resulting ratios of $1.83 and $1.67 are called basic EPS and diluted EPS. It is this latter figure that is generally quoted in any analyses of Microsoft.

However, by probing financial reports you will uncover so-called pro forma income statements. These treat the options as an expense using Black-Scholes calculations like the one above. For Microsoft this new level of earnings of $3,912m gives $1.61 as the basic EPS and $1.47 as the diluted EPS.

With a current price of $130, the diluted p/e of Microsoft is a lunar 77.84. But when pro forma earnings are used it becomes a stratospheric 88.43. The above analysis yields similar results for many companies. In some extreme cases, the pro forma calculations take a positive EPS to a negative one. At the last annual meeting of Berkshire Hathaway, Warren Buffett said that earnings for many companies could be 10 per cent or more lower than what they state because of the use of options and warrants. Now you can see why.

In fact, many think that the overstatement of earnings is much higher. In a report published in April, the London based firm Smithers & Co concluded that by not fully accounting for the costs of their employee share option schemes, the 100 largest U.S. companies overstated their 1995 earnings by 42% and their 1996 earnings by 57%.

Another danger is that when so much of the net worth of the directors and managers is tied up in the value of their companies’ stock via options, there are large pressures on these people to take actions to push up the stock price. This may be achieved, for example, by withholding or lowering dividends and thereby upping retained earnings. Conversely, shareholders would favor a total distribution of earnings so that the options will expire out of the money with the result that the company makes no payments to the option holders.

In the end, I think that a prudent investor with a long-term perspective should try to take into consideration the impact on their portfolio of proper accounting of stock options starting with pro forma calculations. As Morgan Stanley’s Byron Wien wrote recently, the impact "is probably greater than you think and is likely to increase in the future."

You can get more information about the above topic and Valuesoft investment software, and a list of proposed topics, on my web site http://www.sherlockinvesting.com. The title of next month’s article is "To Invest or not to Invest: That is NOT the question." If you have any questions, or suggestions for any future topics, then please contact me at johnp@sherlockinvesting.com.

If you would like to know more about the theory of option pricing, the books Foreign Exchange Option Symmetry (by V.A. Kholodnyi and J.F.P) and Derivatives and Financial Mathematics (Ed J.F.P.) may be helpful.