Hi Don Lloyd; Lets get off the topic of companies with assets on the moon &c., and try to restrict ourselves to the simple question of what effects your proposal has on earnings reports. How's about a simple example? This is the simplest example that I can think of, and it makes pretty clear what is going on.
You wrote that employee stock compensation has the effect of reducing payout to the stock holders. This is true, but it also has the additional effect of improving company cash flow. If the improved cash flow is shown on the earnings number, then the result is that the earnings number becomes exaggerated. The improved cash flow can go to dividends, but it should not be allowed on the earnings line. Here is an example, as simple as I can make it.
I know that this example is extremely simplified. But any more complicated example is harder to explain and will take longer to go through. If your technique for accounting is useful for fast growth companies that continually dilute their stock with employee compensation plans, then it is surely good enough to analyze a simple company.
Example stock plan P&L calculations. The company has a process that produces a cash profit of $3 million per year, if operated on a cash only basis. This profit keeps running forever. Inflation is ignored. At all times I will compute net present value of the company by using a risk interest rate of 5%. There are 1 million shares of stock. This company neither grows nor shrinks, making the analysis particularly simple. The same analysis applies to companies that are growing, even ones that are growing quickly, but it is naturally more complicated. In any case, if an accounting theory is going to work for all companies, then it has to work particularly for the static situation of unchanging profitability.
The value of the company, at 5%, interest is clearly $3/0.05 million = $60 million. Each share of stock has a fair market value of $60. Earnings are $3 per share, and the P/E is 20. Pretty simple, okay?
Now suppose that the company introduces a stock based compensation plan, for just one year, say 1995. The same analysis would apply if a stock based compensation plan were in place for multiple years, but it would be more complicated. In any case, if an accounting theory is going to work for the case of stock based compensation over multiple years, then it must also work for stock based compensation plans that last only one year.
For that year, employees are partialy paid in shares of the company stock, but they aren't going to get them until the beginning of the next year. Employees accept this plan at face value. The company saves $1 million that year in cash compensation costs. In order to give the employees that much worth of the company, they must issue stock worth $1 million dollars after the dilution caused by the stock issuance. The company must therefore issue $1 million / $59 = 16,949 shares.
Note: A simple calculation would have suggested that the company need only issue $1 million / $60 = 16,667 shares, and this is 282 shares than I calculated above. The reason for this difference is the effect of the dilution of the share grant. Since there are more shares availab, each share is worth less. In order to give the employees $1 million worth of stock, the value of the shares owned by the previous shareholders has to decrease by $1 million. Since there are 1 million such shares, the value of the shares must decrease by $1 per share. Hence my division by $59 instead of $60.
If the stock given to the employees is counted at its fair market value, then the earnings per share &c., do not change from the cash based plan. But if the company does not report the stock gift under compensation, then we have the following:
Profit = $3 million + $1 million = $4 million. Number of shares = 1,016,949. Earnings per share = $4 million / 1.017 million = $3.93, a 31% improvement over prior year's earnings. (Presumably the stock flies through the roof.)
In the beginning of the second year, 1996, the company stops the stock compensation plan, and distributes the shares from the compensation plan of the previous year. Because it does this, we can again fully calculate the true value of the company using the traditional technique. The overall company is again worth $3 million / 0.05 = $60 million, as before. Individual shares, however, are now worth a bit less, as there are more of them. $60 million / 1,016,949 = $59 per share. What happened to the missing dollar? It was paid out to the share holders as an extra $1 dividend in the year that the company's cash compensation costs were reduced. (Or it went into a bank account at the company and earned interest.)
Now we can compare the earnings calculations and dividends etc., for three cases. The first is the company not paying their employees in stock. The second case, they pay their employees in stock, but use the GAAP accounting principles. The third case, they pay their employees in stock, but do not recognize stock based compensation.
Employee Stock Comp. in '95
---------------------------
No Plan GAAP no GAAP
---------- ---------- ----------
1994 # Shares 1,000,000 1,000,000 1,000,000
1994 Profit $3,000,000 $3,000,000 $3,000,000
1994 Profit/Share $3.00 $3.00 $3.00
1994 Dividend/Share $3.00 $3.00 $3.00
1995 # Shares 1,000,000 1,000,000 1,000,000 (actual)
1995 # Shares 1,000,000 1,016,949 1,016,949 (fully diluted)
1995 Profit $3,000,000 $3,000,000 $4,000,000
1995 Profit/Share $3.00 $3.00 $4.00
1995 Profit/Share $3.00 $2.95 $3.93 (fully diluted)
1995 Dividend/Share $3.00 $4.00 $4.00 (Assume full payout of cash)
1996 # Shares 1,000,000 1,016,949 1,016,949 (fully diluted)
1996 Profit $3,000,000 $3,000,000 $4,000,000
1996 Profit/Share $3.00 $2.95 $2.95
1996 Dividend/Share $3.00 $2.95 $2.95
1997 # Shares 1,000,000 1,016,949 1,016,949 (fully diluted)
1997 Profit $3,000,000 $3,000,000 $4,000,000
1997 Profit/Share $3.00 $2.95 $2.95
1997 Dividend/Share $3.00 $2.95 $2.95
The cash flows to shareholders is different between the employee stock compensation plan and the cash plan, but the net present value (at the beginning of '95) for the two dividend streams work out to be the same:
For no plan:
$3.00 + $3.00/1.05 + $3.00/(1.05)^2 + ... = $3.00 /(1.05 - 1.00) = $60.00
For the other plan:
$4.00 + $2.95/1.05 + $2.95/(1.05)^2 + ... = $1.05 + $2.95 /(1.05 - 1.00) = $60.00
So it is clear that the employee stock compensation plan did not alter the return to the investors, as it should not. But look at the difference in earnings per share for the GAAP and no GAAP choices of accounting:
GAAP No GAAP
----- -------
1994 $3.00 $3.00
1995 $3.00 $3.93
1996 $2.95 $2.95
1997 $2.95 $2.95
Examine carefully the above table. One of these numbers is not like the others... It is clear that the GAAP method of valuing the employee compensation plan is the one that most clearly represents an accurate estimate of the company's traditional value.
-- Carl |
