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

To: Ted The Technician who wrote (190)	8/15/2002 8:38:42 PM
From: rkral	Read Replies (2) \| Respond to of 786

Ted, welcome to the ESO thread ... Here's some FY2001 numbers (in thousands) for ELON: Revenues........................$76,589 Option Expenses (after tax).....$29,635 Statutory Corporate Tax Rate........35% Option Expenses (before tax)....$45,592 So before-tax option expenses were nearly 60% of sales. That's the worst I've seen yet. Hopefully, that's not new news to you. Ron

To: Ted The Technician who wrote (190)	8/16/2002 11:42:19 AM
From: hueyone	Read Replies (1) \| Respond to of 786

Hi Ted: You have raised a lot of good questions. Here is how I tend to look at things. The first issue for a person to decide is whether they believe stock options are indeed an expense. The second issue to decide is how best to account for that expense on the income statement if one does in fact believe stock options are an expense. I believe stock options are an expense that should be expensed on the income statement when they are granted, and I further believe that because companies have failed to recognize this expense in the past, that the issue of how best to implement accounting for stock options has become a much more thorny than it would be if companies had been expensing stock options all along. With no accounting for stock options, grants of stock options have mushroomed to ridiculous levels. CEO’s pay, including stock options, has grown from 40 times the average worker’s pay in 1980 to well over 500 times the average worker’s pay now. And according to research by Sanford Bernstein, the value of stock options has exploded 12 fold since 1983. Source for increase in CEO pay from 40 times average worker to 515 times the average worker’s pay: e-insite.net Source for twelve fold increase in option value: marketwatch.com So now, precisely because companies have failed to account for stock options in the past, the potential misrepresentations on the income statement resulting from moving to a system of accounting for stock options have been greatly magnified. If we had been expensing stock options all along, there would not be so many underwater options and the potential for misrepresentations when moving these underwater options to an expense on the income statements. I even think we can lay part of blame for bubble inflation at the feet of the failing to account for stock options. Many unprofitable companies looked very profitable using the “free” stock option ruse and were bid up to ridiculous valuations. My suggestion has been, and continues to be, to phase in a system of accounting for stock options that will not be so likely to overstate the value of all the underwater options left over from the bubble. Let’s start fresh right now, and begin expensing stock options as they are granted on the quarterly earnings releases for options granted in 2002 and beyond. The options granted prior to 2002 could continue to be expensed in the footnotes. Once we move to the new system, I presume stock options will be issued in a much more conservative and judicious manner, and hence, the potential for great distortions in the income statements caused by misses with the Black Scholes estimates will not be as great as it is now. I believe the net result will be income statements that are more representative of what the company is earning for shareholders, and that overall, a move to expense stock options on the income statement, may result in more opportunities for private investors to make profitable long term investments in high technology companies. As far as understanding the nuances of the mathematics behind the Black Scholes models, I refer you to Rkal, Exacctnt and Biomaven. I know this post did not directly address many of your interesting questions, and I will be very interested to hear how your study of stock options influences your investment strategy for Elon. Thanks for posting. Best, Huey

To: Ted The Technician who wrote (190)	8/16/2002 12:58:35 PM
From: rkral	Read Replies (1) \| Respond to of 786

Ted, my opinions on a few of your questions .. "If options are expensed at the time of grant, should there be a corresponding windfall when options expire out-of-the-money?" There will be no windfall. FAS 123 has no means of "recovery" of expenses made for options that expire. If adjustments were made, it would likely be a two-edged sword. Expenses would have to be increased for those options exercised with an intrinsic value greater than the "expectation" upon grant, i.e., the "fair value", a.k.a., the option premium. In fact, to be thorough and fair, ALL expenses for options would need to be adjusted to the actual outcome. "Should I be now buying companies that had huge option grant expenses knowing that these options will not be exercised?" IMHO no, at least not based on that information. There will be no expense recovery per above. "should I view the past margins as having been real since out-of-the money expired options does not cost the company anything?" Don't take that viewpoint. The past margins were not real .. since the options weren't expensed .. regardless of the option outcome. I view the expense as the value of the call option on the day of grant. The value is determined using the best information one has on that date. To me it's no different than buying a call option on the open market. The call-writer is not going to give you any of your option premium back after the stock price goes down. "Isn't the value of option grants usually a function of market cap and not a budgeted dollar amount?" Neither. The value of the option grant is determined by: stock price on the grant date, exercise price of the option contract, estimated option life, AND the estimated risk-free interest rate, estimated stock price volatility, and estimated dividends over the estimated option life. These are the inputs to the Black-Scholes equation used in the FAS 123 "fair value method". Hope this helps, Ron