It is an often-overlooked truth, but the ability for investors to accurately see what is going on at a company, and to be able to compare companies based on the same metrics, is one of the most vital parts of investing.

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The debate about how to account for corporate stock options given to employees and executives has been argued in the media, company board rooms and even in the U.S. Congress. After many years of squabbling, the Financial Accounting Standards Board, or FASB, issued FAS Statement 123 (R), which calls for the mandatory expensing of stock options beginning in the first company fiscal quarter after June 15, 2005.

Investors need to learn how to identify which companies will be most affected — not only in the form of short-term earnings revisions, or GAAP versus pro forma earnings — but also by long-term changes to compensation methods and the effects the resolution will have on many firms’ long-term strategies for attracting talent and motivating employees.

A Short History of the Stock Option as Compensation

The practice of giving out stock options to company employees is decades old. In 1972, the Accounting Principles Board (APB) issued opinion No.25, which called for companies to use an intrinsic value methodology for valuing the stock options granted to company employees. Under intrinsic value methods used at the time, companies could issue at-the-money stock options without recording any expense on their income statements, as the options were considered to have no initial intrinsic value. (In this instance, intrinsic value is defined as the difference between the grant price and the market price of the stock, which at the time of grant would be equal). So, while the practice of not recording any costs for stock options began long ago, the number being handed out was so small that a lot of people ignored it.

Fast-forward to 1993; Section 162m of the Internal Revenue Code is written, and effectively limits corporate executive cash compensation to $1 million per year. It is at this point that using stock options as a form of compensation really starts to take off. Coinciding with this increase in options granting is a raging bull market in equities, specifically in technology-related stocks, which benefits from new innovations and heightened investor demand.

Pretty soon it wasn’t just top executives receiving stock options, but rank-and-file employees as well. The stock option had gone from a back-room executive favor to a full-on competitive advantage for companies wishing to attract and motivate top talent, especially young talent that didn’t mind getting a few options full of chance (in essence, lottery tickets) instead of extra cash come payday. But thanks to the booming stock market, instead of lottery tickets, the options granted to employees were as good as gold. This provided a key strategic advantage to smaller companies with shallower pockets, who could save their cash and simply issue more and more options, all the while not recording a penny of the transaction as an expense.

Warren Buffet postulated on the state of affairs in his 1998 letter to shareholders:

Though options, if properly structured, can be an appropriate, and even ideal, way to compensate and motivate top managers, they are more often wildly capricious in their distribution of rewards, inefficient as motivators and inordinately expensive for shareholders.

It’s Valuation Time

Despite having a good run, the lottery eventually ended — and abruptly. The technology-fueled bubble in the stock market burst, and millions of options that were once profitable had become worthless, or underwater. Corporate scandals dominated the media, as the overwhelming greed seen at companies like Enron, Worldcom and Tyco reinforced the need for investors and regulators to take back control of proper accounting and reporting.

To be sure, over at the FASB, the main regulatory body for U.S. accounting standards, they had not forgotten that stock options are an expense with real costs to both companies and shareholders.

What Are the Costs?

The costs that stock options can pose to shareholders are a matter of much debate. According to the FASB, no specific method of valuing options grants is being forced on companies, primarily because not best method has yet been determined.

Stock options granted to employees have key differences from those sold on the exchanges, such as vesting periods and lack of transferability (only the employee can ever use them).In their statement along with the resolution, the FASB will allow for any valuation method so long as it incorporates the key variables that make up the most commonly used methods, such as Black Scholes and binomial, namely:

• • The risk-free rate of return (usually a three or six-month t-bill rate will be used here)
• • Expected dividend rate for the security (company)
• • Implied or expected volatility in the underlying security during the option term
• • Exercise price of the option
• • Expected term or duration of the option

Corporations are allowed to use their own discretion when choosing a valuation model, but it must also be agreed upon by their auditors. Still, there can be surprisingly large differences in ending valuations depending on the method used and the assumptions in place, especially the volatility assumptions. Because both companies and investors are entering new territory here, valuations and methods are bound to change over time. What is known is what has already occurred, and that is that many companies have reduced, adjusted or eliminated their existing stock options programs altogether. Faced with the prospect of having to include estimated costs at the time of granting, many firms have chosen to change, and change fast.

Consider the following statistic: Grants of stock options given out by S&P 500 firms fell from 7.1 billion in 2001 to only 4 billion in 2004, a decrease of more than 40% in just three years. The chart below from Reuters Fundamentals, a data analytics service used by many institutional investors, highlights this trend.

Figure 1: Stock option expense as a percentage of Reuters Fundamentals normalized earnings

The slope of the graph is exaggerated because of depressed earnings during the bear market of 2001 and 2002, but the trend is still undeniable, no to mention dramatic. We are now seeing new models of compensation and incentive pay to managers and other employees through restricted stock awards, operational target bonuses and other creative methods. It’s just in the beginning phases, so we can expect to see both tweaking and true innovation come with time.

What Investors Should Expect

Exact figures vary, but most estimates for the S&P expect a total reduction in net GAAP earnings due to stock options expensing of between 3-5% for 2006, the first year in which all companies will be reporting under the new guidelines. Some industries will be much more affected than others, most notably technology, and Nasdaq stocks will show a higher aggregate reduction than NYSE stocks. Consider that only nine industries will make up more than 55% of the total options expensing for the S&P 500 in 2006, according to a report titled Building a New Consensus: Expensing Stock Options to Drive Analysts’ Estimates Lower, by Credit Suisse First Boston.

Figure 2

Trends like this could cause some sector rotation toward industries where the percentage of net income in danger is lower as investors sort out which businesses will be hurt the most in the short term.

It is crucial to note that since 1995, stock options expensing has been contained in 10-Q and 10-K reports — they were buried in the footnotes, but they were there. Investors can look in the section usually titled Stock-Based Compensation or Stock Options Plans to find important information about the total number of options at the company’s disposal to grant or the vesting periods and potential dilutive effects on shareholders.

As a review for those who might have forgotten, every option that is converted into a share by an employee dilutes the percentage of ownership of every other shareholder in the company. Many companies that issue large numbers of options also have stock repurchase programs to help offset dilution, but that means they’re paying cash to buy back stock that has been given out for free to employees — these types of stock repurchases should be looked at as a compensation cost to employees, rather than an outpouring of love for the average shareholders from flush corporate coffers.

The hardest proponents of efficient market theory will say that investors needn’t worry about this accounting change; since the figures have already been in the footnotes, the argument goes, stock markets will have already incorporated this information into share prices.Whether you subscribe to this belief or not, the fact is that many well-known companies will have their net earnings, on a GAAP basis, reduced by much more than the market averages of 3-5%. As with the industries above, individual stock results will be highly skewed, as can be shown with the following examples (data compiled by Bear Stearns in the equity research report 2004 Earnings Impact of Stock Options on the S&P 500 & Nasdaq 100 Earnings):

Figure 3

To be fair, many companies (about 20% of the S&P 500) decided to clean their windshields early, and announced that they would start expensing their costs prior to the deadline; they should be applauded for their efforts. They have the extra advantage of two or three years to design new compensation structures that satisfy both employees and the FASB.

Tax Benefits — Another Vital Component

It is important to understand that while most companies were not recording any expenses for their option grants, they were receiving a handy benefit on their income statements in the form of valuable tax deductions. When employees exercised their options, the intrinsic value (market price minus grant price) at the time of exercise was claimed as a tax deduction by the company. These tax deductions were being recorded as an operating cash flow; these deductions will still be allowed, but will now be counted as a financing cash flow instead of an operating cash flow. This should make investors wary; not only is GAAP EPS going to be lower for many companies, operating cash flow will be falling as well.Just how much?Like with the earnings examples above, some companies will be hurt much more than others.As a whole, the S&P would have shown a 4% reduction of operating cash flow in the year 2004, but the results are skewed, as the examples below illustrate quite plainly:

Figure 4

As the listings above reveal, companies whose stocks had appreciated nicely during the time period received an above-average tax gain because the intrinsic value of the options at expiration was higher than expected in the original company estimates. With this benefit erased, another fundamental investing metric will be shifting for a great many companies.

What to Look for from Wall Street

There is no real consensus on how the large brokerage firms will deal with the change once it has been proliferated to all public companies. Analyst reports will likely show both GAAP earnings per share (EPS) and non-GAAP EPS figures in both reporting and estimates/models, at least during the first couple of years. Some firms have already announced that they will require all analysts to use the GAAP EPS figures in reports and models, which will account for the options compensation costs. Also, data firms have said that they will begin incorporating the options expense into their earnings and cash flow figures across the board.

Ryan Barnes has more than 10 years of experience in portfolio management and investment research, covering equities, fixed income and derivative products. Barnes has spent the past five years working as an institutional trader and manager for high-net-worth investors, working with Merrill Lynch, Charles Schwab, Morgan Stanley and many others. Ryan is working currently as a writer and financial modeling consultant on hedging and capital appreciation strategies.