Don,
Let me read that carefully again. In the mean time, I just sent this letter off to Gene Epstein regarding his column on stock options in this week's Barrons.
Dear Mr. Epstein,
Great job on the options article.
I feel compelled to point out a few things.
The 8.6% affect on earnings appears to be in line with my own observations. The dilution figures appear quite a bit lower than I have seen. However, there are several small problems with leaving the analysis at that.
The first is that it trusts that the inputs to the Black Scholes model presented in company 10Ks are fair. Corporations have a lot of freedom in their assumptions about volatility and interest rates. I for one am not that trusting. Management can also issue large numbers of options when they feel that the stock is very depressed and award themselves cash when they feel the stock is overvalued. Cleverness about valuation is not part of the model, but most definitely part of the ultimate value of the options.
The second is that it assumes that management will not make questionable financial decisions in attempting to artificially drive up the stock price so they can cash in. More than one company out there is leveraging itself to the max to buy in shares and drive up the stock price. That is a cost of some sort.
The third is that Black Scholes gives us the theoretical value. It does not give us the ultimate value. If a stock increases far more than the assumptions would have suggested, then the ultimate compensation is far in excess of the 8.6% that the economists are coming up with. No corporation is required to repurchase exercised options, but almost all do. Given the roaring bull market since 1995, the ultimate value of the vast majority of options granted in the early 90s is far in excess of their theoretical value. As a result, absolutely enormous amounts of "supposed" earnings and free cash is vanishing from the balance sheet and shareholders equity with no accounting.
It is the third problem that is the most controversial and produces the extremely high costs we see quoted from time to time from people like Andrew Smithers. It is something that our "unbiased friends" from the Fed chose not to look at. :-)
My own view is that the Black Scholes estimates are the best indication of what management wanted to compensate employees, but that ignoring the ultimate cost is a gross error.
Right now enormous amounts of free cash are being absorbed repurchasing exercised options that no one thought would be worth this much. Therefore, the dividend paying ability of corporations is being impaired and the accumulation of shareholder equity is much lower than reported earnings would indicate. Where this cost belongs I do not know.
It is variable.
It is not calculable when the options are granted.
It is not reflective of management's compensation desire.
It is not likely to be repeated.
All I know is that when I look at the cash flow statement of one of my companies, I sometimes see 35% of the reported earnings being used to repurchase exercised options. At the end of the year I own the same percentage of the company as I did when it started, but 35% of my earnings is missing. THAT belongs somewhere!
Wayne Crimi |
