Silicon Investor (SI) -- The First Internet Community

STOCKTALK

We've detected that you're using an ad content blocking browser plug-in or feature. Ads provide a critical source of revenue to the continued operation of Silicon Investor. We ask that you disable ad blocking while on Silicon Investor in the best interests of our community. If you are not using an ad blocker but are still receiving this message, make sure your browser's tracking protection is set to the 'standard' level.

Technology Stocks : Qualcomm Incorporated (QCOM) -- Ignore unavailable to you. Want to Upgrade?

To: kech who wrote (114213)	2/24/2002 11:18:46 PM
From: Stock Farmer	Respond to of 152472

I hope that in return for this option you will also remit a portion of your salary to me in return and that you also promise to align your interests with the company for the duration of your ownership of your options. <g> Of course this is the logic the company uses to grant these options. And now we are getting somewhere. These attributes the company would ask of me (reduction in pay, fealty... ) in order to first give me a call option on the shareholders' property, they have value, yes? If the company wasn't giving me the shareholders' property, then it would have to pay cash (or something else) to get these desireable things that lead to their ability to generate revenue. Yes? So this is actually an economic cost of production. And yet it doesn't appear on the books anywhere. Interesting. So let's run with this for a second. We need an example. Start with a legitimate business. Let's say 80% of cost is labor, 20% materials, effective tax rate is 35% and gross margins are 5%. Let's assume they have 100 Million shares outstanding. Revenue 100.00 M$ Cost Labor 73.85 Materials 18.46 ------ Total Cost (92.31) ------ Gross Margin 7.69 M$ Taxes @ 35% (2.69) ====== Net Margin 5.00 M$ EPS $0.05 Fully Diluted EPS $0.05 PE @ 20 gives share price $1.00, Market Cap 100 Million P/S ratio 1 Now take the same business assuming we can convince the employees to take a 20% haircut in salaries but stock options instead. The size of the grant is such that they get 100% of their salary difference (20% of their salary) if the stock doubles over the holding period (10 years, that's 7% CAGR). Salary cost is 73.85 20% Savings is 14.77 40% Salary is 29.54 We have 100 M shares at $1 each and want to issue 29.54 M$ in options at a fair market value strike of $1... 29.54 M shares or 29.54% of float. This is roughly in line with the size of an option pool in a pre-IPO startup. Our revised financials look like: Revenue 100.00 M$ Cost Labor 59.08 Materials 18.46 ------ Total Cost (77.54) ------ Gross Margin 22.46 M$ Taxes @ 35% (7.86) ====== Net Margin 14.60 EPS $0.15 Fully Diluted EPS $0.11 PE @ 20 gives share price $2.82 You see, right off the bat our company appears to be much more profitable. Not only that, but our share price more than doubles for the same PE (2.82 instead of 1.00) so our employees actually get 136% of their salary right away. And then if they exercise (which most do, just as soon as the shares vest), we see another effect. Our other books are modified as follows Before After Cash Flow Earnings $5.00 14.60 Option Tax Credit -- 18.81 ----- ----- 5.00 33.41 CF Operations Shares issued -- 29.54 ----- ----- CF Financing -- 29.54 ===== ===== Total Cash Flow $ 5.00 $ 62.95 *** Balance Sheet Retained Earnings 5.00 14.60 Paid In Capital 48.35 Shareholder Equity 5.00 62.95 So you can see that our ordinary little business has been miraculously transformed into a cash generating wealth accumulating machine! And the cool part about it is that as the price of the stock rises, the less you have to give away for even greater effect! Of course, it's the exact same business with the exact same customers. Just the books look remarkably different, and shareholders (curiously enough) pay more for the company when they are footing the bill for salaries than they would if the company does the job. But do you think Joe Sixpack would pay more for the same business? So how real is that "market cap" number anyway? And what would Joe Sixpack pay for that business if he was a smart guy? How would he do the math to figure it out. Get inside his head and then divide his purchase price by the number of outstanding shares. Let's see... He's not dumb. He knows it's worth 100 M$ divided by 129.54 M shares. Gee, that's $0.7719 per share. So those smart shareholders who voted in the stock option incentive plan really did themselves a favor, yup yup yup. The wonders of modern accounting. This is of course a hypothetical exercise but it does illustrate what is going on here. And I hope it makes my point much clearer. You asked More seriously, are you suggesting that the problem is that the company is giving the stock option to the employees but not "hedging" the risk that the options appreciate a lot in value? Actually, I don't care personally. All I care about is that the economic cost of production is reflected accurately somewhere, and that profits are not artificially overstated by giving away something that belongs to shareholders and pretending that it cost nothing. John.