Are Stock Options a Big Deal to Investors?
Friday July 9, 7:00 am ET
By Geoffrey Bonn
Dear Analyst,
What is all the fuss in regards to recording an expense for stock options? How, exactly, are stock options a cost to the company?
Mike C.
With the issue of stock-option expensing popping up in op-ed pages and Warren Buffett publicly weighing in on the matter, this has been a hot topic lately. As most investors are aware by now, stock options are a commonly used incentive that companies grant to employees to reward them for the company's long-term performance. When an option is exercised, or bought by the employee, there is a very real economic cost to the company. We'll work backwards from this cost and then consider how the assumptions a company uses in estimating the value of an option at the time of grant can impact the adjusted earnings estimates provided in the footnotes to the financial statements.
Real Economic Costs
When an employee purchases a stock option, he or she pays the strike price of the option, often referred to as the exercise price, and receives one share of stock for every option exercised. The company issues the share directly to the employee, usually out of a pool of shares designated by a stock-option plan that was approved by shareholders. The strike price is always below the current market price; otherwise the employee would buy the stock on the open market. The employee can then sell this share at the market price or hold on to it with the hope that the stock price will continue to appreciate.
Because the strike price is below the current market price, the company incurs a cost equal to the difference between the current market price and the strike price to issue shares at this discounted price. For example, if the employee has a stock option with an exercise price of $1 and the company's stock is trading at $11, issuing the share costs the company $10 versus selling that share on the open market. The IRS recognizes this difference as a compensation expense and allows the company to take a tax deduction on the difference between the stock price and the strike price. In this case, the company would be entitled to a $3.50 tax deduction, assuming a tax rate of 35% ($10 x 0.35 = $3.50) as a result of this option exercise.
The cost of issuing stock to cover exercised options can be staggering. We can estimate the total cost by dividing the tax benefit of employee stock plans (usually a line item in the operating activities section of the statement of cash flows) by the federal statutory tax rate, which is generally 35%. For example, Dell (NasdaqNM:DELL - News) recognized $181 million in tax benefits associated with employee stock plans in fiscal 2004. Dividing this tax benefit by the statutory tax rate gives us an estimated cost of $517 million--half a billion dollars. If we add this amount to the cost of share repurchases that companies often undertake to control the impact of option grants on dilution ($2 billion in fiscal year 2004 for Dell), the cost is even more substantial.
Estimating Fair Value
Because stock options have a very real economic cost, we strongly believe that companies should expense stock options on their income statements. Companies are already required to estimate the expense for all stock options granted during the year in the footnotes to the financial statements, but most have balked at including the cost of options in reported income statements. By far, the most popular method that companies use for estimating the value of stock options is the Black-Scholes model, an option-pricing model originally developed for exchange-traded options. While there are arguments aplenty regarding the merits of the Black-Scholes model, we'll look at two key inputs to the model--expected life of the option and stock volatility--and how these inputs affect the estimated fair value of the stock option.
All else being equal, the estimated fair value of the option increases with the length of its expected life. So it is useful to look for trends in the expected life of the option, that is, whether or not the company is increasing or decreasing the expected life. For example, Microsoft (NasdaqNM:MSFT - News) increased the expected life of its stock options from 6.4 years to 7.0 years between 2001 and 2002. On the other hand, Intel (NasdaqNM:INTC - News) dropped the expected life of stock options from 6.0 years to 4.4 years between 2002 and 2003. In general, we prefer to see companies maintain or increase their estimate for the expected life of an option because reducing this number will effectively lower the company's estimate of the cost of issuing options.
Increasing the stock volatility also increases the estimated fair value of a stock option. Again, we look for trends in the volatility used to calculate the estimated fair value using the Black-Scholes model. Johnson & Johnson (NYSE:JNJ - News) increased the stock volatility assumption from 26% to 28% between 2002 and 2003, whereas Hewlett-Packard (NYSE:HPQ - News) reduced the stock volatility assumption to 35% from 37% between 2002 and 2003. As with the expected life of an option, we like to see companies be more conservative with their accounting assumptions and maintain or increase their volatility estimates.
The Bottom Line
Estimating the fair value of stock options is tough, but that doesn't mean it is not worth doing. It is valuable to look at trends in the assumptions used to determine whether the company is becoming more aggressive or conservative in its cost estimates. Finally, it is a good idea to do a "gut check" of the assumptions by comparing the current year's estimated cost of options granted with the estimate of the cost associated with exercised options as we calculated earlier. What's the big deal? The bottom line is that skipping over these compensation costs would ignore the fact that a potentially significant portion of the firm's value will go directly to management and employees, not investors. Considering the impact of stock options can help investors make more accurate assessments of a company's true value.
biz.yahoo.com |
