What If Expensing Options Wasn't Optional?

It's all over the news lately: Heavyweight companies like General Electric, Boeing, Coca-Cola, even General Motors are announcing plans to count employee-issued stock options as an operating cost on their balance sheets. Why is this making headlines? Stock options are a form of compensation, just like cash bonuses and salaries. But whereas bonuses and salaries are deducted from profits, counting options is optional, and only a handful of companies in the S&P 500 figure stock options into their bottom lines.

How will things change as more companies own up to their options? David Blitzer, the chief investment strategist of Standard & Poor's, figures that if the cost of options for all the companies in the S&P 500-stock index had been deducted last year, they would have reduced the profits of the S&P 500 companies by about 22%.That's higher than usual because corporate profits were low last year. Options normally eat up 10% to 15% of total S&P earnings per share.

In Federal Reserve Chairman Alan Greenspan's view, the greatest risk is if investors take reported earnings at face value. Expensing options will drive down profits and, conceivably, stock prices. It's possible, then, that employees would look at options as being less valuable, and probably fewer companies will grant them as perks.

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In the best case scenario, all that will change will be the format of annual shareholder reports. Worst case scenario: companies that omitted stock option expenses will wind up with a distorted market value, and investors will learn they've been putting their money into inefficient, or worse, unprofitable businesses.

A little background

Stock options give the holder the right to buy stock in the future at a "strike" price fixed when the option is granted. If the stock goes nowhere, neither does your net worth. You could get rich if you buy at a low strike price and sell when the stock takes off.

Stock options are granted to employees typically as an incentive to bolster company performance. Innovative or high-growth industries, such as technology, telecom and biotech -- which tend to be cash-poor -- often use stock options as a lure or reward for talented employees and to attract capital investments. And a large chunk of a CEO's compensation comes in the form of stock options.

Right now, most companies list stock options as a foot-noted item on the annual report. They are not formally counted against profits. Analysts and money managers usually know to look for them, but if you're like most investors, you probably don't bother with the fine print.

If the Financial Accounting Standards Board, which sets accounting rules in the U.S., were to make expensing stock options a requirement -- and there's a strong possibility that will happen by 2004 -- then companies would be forced to come up with a fair value for the options. This is where the potential for fuzzy math comes in.

Options traded on the options market are traditionally valued using the Black-Scholes option pricing model, a complex system that accounts for such factors as volatility, interest rates and the stock price versus the strike price. But this is an imperfect way to value stock options.

Then there's the question of what happens if a company decides to expense its options, assigns the options a value for that fiscal quarter, and then sees the stock price slide. "Then that expense really didn't exist in that quarter," says Joe Cooper, a research analyst for Thomson Financial/First Call, and no one is sure how that will be dealt with.

Is it fair?

Understandably, some companies are crying foul against options expensing until there's a fairer method of determining stock options' values. Intel, for example, just announced that it would not expense options. "We believe the current debate over the use of stock options is misdirected," Andy Bryant, Intel's chief financial officer said in a statement. "Rather than focusing on the accounting for broad-based employee stock options, the debate should center on excessive executive compensation."

Having the information is a good thing -- it means you have a truer picture of a business's profitability, Cooper says. "My problem with options expensing right now is that it destroys analysts' ability to clearly forecast earnings for a company." And earnings growth is usually the first things investors look at when they size up a company.

Microsoft, for example, reported 2001 earnings of $1.32 per share. Had the company counted vested stocks options granted to its employees, profits for the same time period would have dropped to 91 cents per share.

Bottom line: Expensing options does not change the actual operations or the cash flow of a corporation. If investors are put off by lower earnings, says Greenspan, it only means that they are less informed about the actual costs of doing business.

And it's never a good idea to focus solely on an earnings number. It's just as important to consider other indicators of financial strength, such as cash flow, revenue and return on assets. As more and more companies count options as a compensation cost, earnings outlooks will be restated, and in all likelihood they'll be lower. Be ready for it -- it doesn't necessarily mean bad news.