A last argument used to support option expense accounting -
Finally, there is an argument in favor of option expense accounting that is not wrong, in and of itself, although the basis for its use is highly questionable, IMO.
This argument consists of the following -
If we take two hypothetical companies that primarily differ in that the first pays only cash wages, and the second makes option grants part of its compensation package, then not accounting for the option grant as an expense gives the second company an advantage in presenting its earnings results and the earnings reports of the two companies are not directly comparable when looking at the bottom line.
This is almost certainly true, but so what? Anyone who believes that they should be able to make investments based entirely on reported accounting results would likely be just as successful bidding on Eastern metropolitan bridges with the intent of shipping them to the Left Coast and charging tolls. Every company is different, and different along multiple dimensions, and it is simply unreasonable to expect that any accounting system can possibly compensate for those differences and distill them into a set of directly comparable numbers.
Moreover, the wishful thinking of investors that asks for such a system is misguided. In the limit, naive investors would ask that accounting supply a single price for each company which, if paid, would yield the total return of risk-free treasury securities. In the event that such a wish were granted, it would eliminate any reason for equity investing to exist, as there would be no return to superior knowledge or skill, no means of exchanging risk, no reward to entrepreneurs for satisfying consumers, and no market to serve as a driving force to help to efficiently allocate economic resources.
In addition, this wishful thinking does not take into account the real purpose of accounting. Accounting is a service that is paid for by the existing shareholders of a given company to help assure that the management of the company both operates in a legal manner and fulfills its fiduciary obligations to its shareholders. This is true in spite of the fact that accounting may perform this function rather badly, in many, if not all, cases.
When, and if, accounting becomes a function that is paid for by potential investors to provide a level database for multiple companies so that investors can choose investments by mindlessly running a computer search; then, and only then, do investors have a legitimate complaint.
Changing the focus, companies that are able to exchange partial contingent ownership for lower cash salary compensation for its employees are different than companies that cannot. In addition, between reduced cash compensation, option exercise payments and tax deductions, such companies in fact do realize increased free cash flow and, to the extent that this advantage is not excessively diluted, deserve higher valuations. If this is the case, any management that does not pursue option grants is failing to maximize shareholder value.
Just to be clear, I am only defending the granting of options itself, not an excessive level of it, and not many of the actions which are associated with option grants. For example, naive investors are often guided to reward companies that buy back their shares without qualification. This is, of course, ridiculous. Buying back of stock with shareholder funds is simply one of an infinite number of investment possibilities, and it must be the best choice of investment, strongly taking price and outlook into account. If the rate of stock ownership dilution due to ongoing option grants cannot stand up to detailed scrutiny without any offsetting buybacks, then the rate is almost certainly excessive.
Regards, Don |
