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To: Allen Benn who wrote (3415)	7/16/1998 11:59:00 AM
From: Allen Benn	Read Replies (2) \| Respond to of 10309

TOWARD AN UNDERSTANDING OF STOCK OPTIONS. Historians probably will judge Fisher Black, who recently succumbed to an untimely death at 57, one of the most influential economists of the 20th Century due to his central role in the development of the Black-Scholes formula for valuing financial derivatives. An option to buy a share of stock at the current market price over some specified period of time has an economic value somewhere between zero and the current price of the stock. Certainly it can't be negative, and likewise it can't exceed the stock's market value or else the option will simply be flipped on the spot for the stock. While it should be evident to anyone that volatility of the underlying stock adds to the value of the option, Black et al were able to provide a relatively simple and incredibly general formula for the exact value of the option. The only significant assumption behind the formula is that the stock market must be efficient, which many scientists believe for lack of strong evidence to the contrary. The Black-Scholes formula literally transformed the security industry and is trusted as the foundation for trillions of dollars of hedging and related transactions involving derivatives. In short, the Black-Scholes formula provides a proven yardstick for valuing most types of options, and is certainly a metric acceptable to the Financial Accounting Standards Board. An option has an economic value when granted equal to the present value of its expected return. If we think we know what that value is, then that value becomes the expected cost that someone has to cough up when it comes time to exercise the option. In other words, the value of an option must be borne as an expected cost to whoever sells or writes the option. There are no free lunches. Of course, the someone who underwrites the option is the stockholder. Traditional accounting ignores this cost (when the option price equals current market price), and even fails to tally it when options are exercised. The dilution caused by stock options traditionally is reflected in so-called "share growth", perhaps reduced by open market purchases of stock that do not show on the books as an expense. The non-operational cost treatment of stock options is grist for anyone who thinks options should be treated formally as a component of employee compensation. The theoretical applicability and widespread acceptance of the Blacks-Scholes pricing formula makes it the mechanism of choice to make transparent the options component of employee compensation. But now let's get real. Most complaints about stock options focus on actual dilution and/or costs of stock buybacks with the aim of funding employee option packages, not on a calculation of the expected cost of the option. Nobody cares what the value of an option was when granted; the issue is how much each option is costing shareholders now. Why not alter FAS 123 to adjust the cost of options for actual changes in the underlying price of the stock? Potential dilution, option costs, everything changes dynamically with the price of the stock, and could easily be calculated as part of FAS 123 procedures. (FAS 123 as is stands is like booking expected revenues on the basis of a proven sales forecasting model. Some accounting standards are getting fuzzy, but that's going too far.) The problem with including updates based on actuals in a modified FAS 123 is that it would wreck accounting havoc, not that it would be difficult or less meaningful. Suppose WIND issues options on one million shares at a strike price of $35, then quickly jumps three-fold on the market's realization I2O really is becoming a standard for I/O. The value of the options will have increased by more than $70 million, which would almost double operational costs for the year if the actual cost of stock options were included, yielding a huge paper loss. This makes no sense to anyone, including accountants at the FASB, even though in this case employee compensation really would be astronomical. So the FASB sidesteps this reality by recommending that Black-Scholes be applied statically, knowing that results will thereby always appear to be within the realm of reason. This little "impracticality" cannot properly be papered over by embedding FAS 123 in sophisticated formulae. This makes knowledgeable people refer publicly to these kinds of machinations as "theoretical". There simply is no reasonable way to account for the cost of stock options as a component of employee compensation, and have EPS retain any useful meaning. It is not that the Black-Scholes pricing formula is wrong necessarily. The problem is the investor has only passing interest in the value of stock options at the time they are granted. In the final analysis, the investor is very interested how much his/her stock is being diluted. But since employee stock options represent contingent liabilities, which only apply if you don't mind paying for them, they can't adequately be included in operational costs using any formula. Analysts typically project growth in shares from stock options along with earnings. Consequently, projected growth in EPS normally accounts for stock options, which should be sufficient for most investment decisions. Additional detail in annual reports about outstanding stock options is useful for helping investors decide if a company is too exuberant granting options. Stock buybacks is a subtle side issue often intertwined with employee stock options, sometimes for reasons that have little or nothing to do with dilution. The next post in this series is an attempt to help investors appreciate implications of this important management tool. Allen

To: Allen Benn who wrote (3415)	7/16/1998 10:05:00 PM
From: Pirah Naman	Read Replies (1) \| Respond to of 10309

I doubt that Dick Kraber can give you a satisfactory answer to your questions in a public forum. It is not my place to speak for Mr. Greene (any more than it is your place to speak for Mr. Kraber), but he did explictly state in his post that the submitted these questions to Mr. Kraber in private over a week ago. Why should investors feel niggardly toward the very people breaking their necks to make the company successful That reads like something a politician would say. :-) "Anybody who questions my policies is obviously a dirty rotten scoundrel who believes..." Additional detail in annual reports about outstanding stock options is useful for helping investors decide if a company is too exuberant granting options. Yes. And if you review Mr. Greene's letter, you will see that he is asking for WIND's input to clarify that very matter. How management decides to allocate capital is something a sophisticated investor considers. The questions posed to that end are deserving of an answer - from WIND. Asking (or challenging) towards getting an understanding is not something which calls for a defense or for the best possible spin to be put on things. And no matter how you dress it up, the statement of cash flows in the annual report shows a significant percentage going to repurchase shares. Share count subsided for the fiscal year just ended due to repurchases of stock. How did you come up with that? or maybe I should be asking what is your definition of subsiding?