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January 14, 2006

Comments

gundryggia

I am less sure than you that we want managers to be long volatility but it's an interesting argument.

A few points look suspicious to me, however:

"Even the almighty Internal Revenue Code agrees that the recipient of options has income only when the option is exercised."

So what? This strikes me as a rhetorical strategy rather than an argument. If Hypothetical Holdings loses or gains a few billion on its stake in Company X, but has not yet sold the stock, isn't that something that investors would want to know about? If I'm investing in Goldman Sachs, do I just need to see quarterly income based on already closed-out trading positions, or am I going to want to see mark-to-market P&L as well?

"In order to compare the performance of Intel and McDonald’s, an investor will need to adjust for the fact that Intel’s earnings are disproportionately reduced by the recognition of more expense per option granted."

Why would an investor want to compare the quantity of options granted, of all things? She cares about the value of the options, and the Intel options are more valuable.

"...what shareholders want. Do they want managers who see themselves as employees? Or do they want managers who act like partners working for piece of the action?"

I agree that the question is ultimately what shareholders want. But how exactly does expensing stock options prevent investors from making that choice? If stock options are a good form of compensation, investors will surely reward companies that use them after they are accurately reported. Won't they?

(Please don't claim it's going to traumatize the market by screwing up analyst EPS models or some such. I am reasonably confident US equity markets can survive the transition.)

Matt Bodie

I'm also not sure about the upside-risk argument as to stock options (vs. stock). Do we really want a compensation mechanism that is indifferent as to whether the stock price goes down $0.01 or $100?

Broc Romanek

Welcome to the blogosphere! Too bad I disagree with this entry. Many companies treated options like candy since there was no expense involved - and the overhang level became very dangerous. Grant practices became routine for senior managers at many companies, without consideration for whether they could really incentive management any further. This topic has been debated to death and sanity has prevailed.

geoffrey manne

For some reason the trackback didn't work. Find my (brief) comment on this post at Truth on the Market at http://www.truthonthemarket.com/2006/01/31/the-costs-of-options-expensing-rules/

Tom Bozzo

"Aside from the difficulties inherent in expensing options, it is not clear that options do have a cost."

On the contrary, your own examples clearly demonstrate that the options grants have an opportunity cost at the time of the grant. E.g., an option granted by Intel as part of an employee's compensation package could, in principle, have been sold on the market for $X -- the amount depending on the expiration date and strike price -- instead, with no effect on (potential) dilution. So the option has some ex ante cost even if it ends up going unexercised ex post: the company could have had something ($X) instead of nothing (or, more precisely, $X versus the marginal incentive value of the option -- which, as Broc Romanek notes, is not obviously guaranteed to be greater than $X).

For fun, one can imagine a counterfactual tax system in which options grantees can pay tax on the market value of the option at the time of grant instead of on the profit at the time of exercise, and the tax treatment argument fails, too.

Dale Wettlaufer

Paraphrasing Warren Buffett, the second-wealthiest person on Earth, who achieved that distinction though thinking through these things effectively:

If options are not compensation, what are they? If compensation is not an expense, what is it? And if expenses don't belong on the income statement, where in the world should they go?

The idea that options issuance shouldn't be counted as an expense because it reduces EPS misses the point. You can issue equity or an equity equivalent and use that directly or indirectly to pay for something in that same accounting period. What if a corporation issued stock for cash in the first quarter and purchased with that cash in Q2 services it fully consumed in that quarter? That would reduce retained earnings and increase shares outstanding in the fiscal year. What if it purchased a new steel plant with that money and put it into operation that year? The depreciation would be spread out over a number of years, but the depreciation would still be an expense and the shares outstanding would still be higher. Why is it any different with labor? I would argue it's no different.

The corporation (1) issues stock or an equity equivanent, (2) which increases equity, (3) to purchase something, which becomes (4) an expense and (5) reduces retained earnings and increases (6) shares outstanding. Whether it reduces or increases EPS depends on whether management bought something of value, whether it's a steel mill, your labor, or services.

Presumably, the corporation is receiving something of value that generates more revenues over the course of the consumption of that good or service than the expense in question. If so, then yes, it is increasing expenses, but the higher expenses are also going to increase earnings. Bottom line, there's no reason why something can't be an equity component and an expense in the same accounting period.

Geoffrey

Could you help me. Well done is better than well said.
I am from Italy and learning to write in English, tell me right I wrote the following sentence: "Authorsfor someoto gain weight, athletes need to consume more calories than they expend."

With respect 8-), Geoffrey.

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Interesting article..
I agree with you that the question is ultimately what shareholders want. But how exactly does expensing stock options prevent investors from making that choice? If stock options are a good form of compensation, investors will surely reward companies that use them after they are accurately reported. Won't they?

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it costs more for a growth company to use options as compensation than it does for an established company to do so.

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but also because growth companies tend to grant more options.

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