Wayne -
Thanks for your reply. Your answers seem perfectly reasonable, but, in my opinion, they are not correct for reasons that can also apply to the accounting of options expense.
Original Text -
"Assume a diamond mining company located on a volcanic island in the South Atlantic. It is not subject to any taxes and has an ADR listed on the NYSE. It is a fully above-board company whose Chairman is John Templeton. It fully complies with U.S. and NYSE accounting rules.
The Annual Report has just been published and full year revenues are $1B ($1,000,000,000) on sales of 1000 large diamonds at an average price of $1,000,000. All pertinent data, including earnings and outstanding shares, are disclosed, but the actual numbers are not believed to directly impact the discussion below. The company believes that it has diamond reserves that will allow it to continue in business under current conditions for at least 100 years.
Last year, the President received a salary of $250,000, but in future years he will be compensated with a salary of $100,000 and will additionally receive a diamond of about $1M in market value. No restrictions are placed on its disposal.
Question 1. - Should future earnings reports make any expense adjustment for the diamond compensation? What number should appear for the President's compensation expense?
Question 2. - Next quarter, an investor will look at the quarterly report for revenues, earnings, etc. and will value the company accordingly by whatever means he deems appropriate. Does the change in the President's compensation change the valuation an investor should place on the company? If so, how?"
Answer 1a. No, there should be no expense adjustment.
1b. $100,000
Answer 2a. Yes, the company valuation should INCREASE.
2b. The valuation should be increased to nearly the amount that would be implied by an increase of $150,000 per annum in free cash flow, due to the reduction in salary compensation expense.
Austrian Explanation -
The economic cost of choosing a most preferred action 'A' over all other alternative actions, is the preclusion of the possibility of choosing action 'B', the second most preferred choice, and realizing the benefits of action 'B'.
In this case, action 'A' is the payment of a diamond in exchange for a reduction in cash compensation of $150,000.
Action 'B' is all the things that can no longer be done as a result of paying one diamond in compensation.
1. Action 'B' does NOT preclude the company from selling and profiting from its normal 1000 diamonds per year.
2. The compensation diamond represents a reduction in diamond reserves by one. However, this has no effect on possible sales until the reserve is totally exhausted. In other words, the compensation diamond is effectively the last one in the reserve and only comes into play, from the point of view of revenues, after more than a century.
3. Thus its impact must be discounted to a present value. If we look at it in reverse, the additional $150,000 in free cash flow could be invested at 6% and would compound to about $40M in the 100 years that would pass before the compensation diamond reduced potential sales by $1M.
4. Besides the effects of reserve reduction, there are some current costs involved with the compensation as follows -
a. The President's secretary must take 15 minutes and go get the Inventory Vault guard to unlock the Vault so that she can tag and reserve a particular diamond for the President. This is a cost that precludes 15 minutes of other work for both the secretary and the guard. However, it is the marginal 15 minutes, the lowest priority tasks, that are precluded. In the case of the secretary, she will lose 15 minutes of painting her nails one day a year. For the guard, he will lose 15 minutes of uninterrupted sleep.
However, the wages paid to the secretary and the guard will not increase at all, and are already fully accounted for in the labor expense column, as long as there is some slack. But even if there were a new requirement for labor, it will appear in the normal accounting lines, and not need a special executive compensation line.
b. From the operational mining point of view, the compensation diamond comes from inventory. Since there normal fluctuations in both yield and sales, a buffer is normally maintained. The extra diamond merely represents a minor change in the timing of a switch from inventory depleting to inventory building. The marginal cost of the mining of the extra diamond simply relates to a small change in the balance of actual mining vs preventative maintenance, assuming that some necessary slack exists. Again, any actual additional costs already appear in the labor expense line, not needing a special executive compensation line.
Market effects -
Normal sales consist of placing 1000 diamonds each year in the hands of the public. The compensation diamond is just one more, as the President is just another public holder. The effect can be considered as equivalent to advancing the company's sales efforts by about 8 hours (1/1000 year).
Summary -
The actual costs to the company are not only negligible, but are overwhelmed by the benefits of the extra free cash.
The key point is that expense costs to the company need not have any necessary relationship to the market value of the compensation to either the recipient or some third party.
Option valuation must follow a similar path. Using the market value of options is totally wrong. The implied option market value has virtually no relationship to actual company costs. The real problem, as you have indicated, is the tendency of companies to spend shareholder funds to buy back shares at any price to hide real dilution.
Regards, Don |
