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Strategies & Market Trends : Employee Stock Options - NQSOs & ISOs -- Ignore unavailable to you. Want to Upgrade?

To: rkral who wrote (133)	7/27/2002 8:17:54 PM
From: hueyone	Read Replies (1) \| Respond to of 786

Hi Ron: Welcome back! For awhile there I thought maybe you had retired from SI.<g> The issue of expensing stock options has continued to gain traction and visibility in the news during your absence. Do you have any problem with the "no cash flow" aspect of option costs (the FAS 123 portion)? I don't know whether this answers your question Ron, but what I have a problem with is people tending to dismiss the importance of expensing stock options on the income statement with the refrain that "even if we expense stock options on the income statement, free cash flow will not change, and free cash flow is all that matters". I disagree with that contention. In my opinion, the free cash flow calculation is intended to measure the "the residual left over for the common shareholder from operations after the enterprise has replenished any 'wasting' assets (PP&E, intellectual property, etc.) necessary to more or less sustain its productive capacity to generate cash flow". If folks simply calculate free cash flow by taking cash flow from operations and subtracting Capex, they will presumably recapture the non cash expense of employee stock options that would likely wind up appearing in the section titled "Adjustments to reconcile net income to net cash provided by operating activities", and, hence, would end up with the same free cash flow number they had when stock options were not expensed. In my view, this free cash flow number does not reflect the purpose of the free cash flow calculation. This free cash flow number will be inflated by a financing activity---that of issuing shares in lieu of cash compensation. Here is my best guess as to how to measure free cash to gain a meaningful number when stock options are expensed on the income statement---Net income plus Depreciation and Amortization plus Tax Benefit from Exercise of Stock Options less Capex. (Since we are expensing stock options it only seems fair to include the resulting the tax benefit in the overall equation if it is not already included in the income tax figure). More importantly, we will have a useful free cash flow number that will compare more fairly with companies who are compensating their employees with cash instead of stock options, and we will have a better approximation of what dollars that the company is generating from operations over and above Capex. What is your opinion? Best, Huey

To: rkral who wrote (133)	7/28/2002 12:22:32 PM
From: Clarksterh	Read Replies (4) \| Respond to of 786

rkral - Reply to post on other thread. You are right that currently the IRS 'earnings sheet' allows a deduction for options exercised by employees and the size of the deduction is equal exercise price minus strike price. But several points: 1) There does not seem to be a settled method of accounting for options. For instance Coke (and The Washington Post?) are using some obscure method for which I have not yet seen a good description. And then the pro forma reporting done in all of the 10Ks according to the FASB rules uses Black Scholes. And there is a thought, not unreasonable in my opinion, that the IRS earnings sheet and the GAAP earning sheet should be better sync'd up. Yes, we will probably continue to use the current IRS system, but it is possible that it will be changing. 2) Regardless of which method is used for accounting for options, there will be a permanent disconnect between the cash flow and earnings. Cash flow always matters to a company, earnings do not except in so far as they effect taxes and public relations. When this happens there is a strong incentive to do manipulate earnings in order to benefit your cash flow in the opposite direction. In fact one of the complaints given by the proponents of expensing options is that they wrote too many recently. Well of course they did since it was phenominally beneficial to their cash flow and still will be. BTW - You have really come up to speed on all of the FASB stuff. Did you order a copy of some of the letters? BTW2 - I have tried to find out whether total dilution includes only vested options or not, and although I am not sure I believe it is only for vested options. The only reason the dilution sometimes exceeds the number of employee options outstanding is that dilution includes warrants, ... having nothing to do with employees. Also note that the way dilution is calculated is, IMO, bizarre. It essentially assumes that no one ever actually exercises an option except the extent that they can get the required cash by selling the rest of the options. Thus the dilution for an in the money option is higher for lower exercise prices. Clark