Greed & Options – Asset Reallocation

Paul N. Jaber, Jr., CFA
Oct 8, 2003

The Under Reported Scandal

As the end of the year approaches I thought it would be nice to look back and review.  The past two years have been filled with accounting scandals, Wall Street scandals and most recently mutual fund scandals, all of which might logically have been expected after the speculative 1999 – 2000 period.  Though the biggest scandal, the huge transfer of wealth in corporate America to management and employees from shareholders, has really not yet been aggressively reported.

With all the attention being paid to the blatant Enron, Tyco, Qwest, and World Com frauds, investors have lost focus on the issue of accounting for stock options, or more specifically whether or not they should be included on the income statement as an expense.  In my opinion the damage done and going unnoticed from excessive stock option grants, is greater than any of the other corporate scandals of the past few years.  Through options, actual cash that belongs to shareholders is being shifted to management under the guise that the activity is a non-cash transaction.

The options culture is fueled by the same themes behind all the recent scandals: greed and a complete lack of fiduciary duty on the part of management to their shareholders.  This massive reallocation of capital began in the early 1990’s when options use started growing in popularity.  Understand one thing, for most of the Nineties, culminating during the bubble years, and continuing today, there was a paradigm shift in the financial markets.  I am not talking about the silly paradigm shift relating to new ways to value technology companies (that is and was pure fiction), I am talking about the powerful shift from running corporations for shareholders to running them for management.  To steal a line from Tom Brokaw, this is a massive fleecing of America and it will eventually hurt our capitalist system.

Hoodwinked into Believing Everyone was on the Same Side

In its advent, the stock option was trumpeted as aligning management’s interests with shareholder interests.  Instead of being guaranteed excessive cash salaries, management and employees would be forced to have some proverbial skin in the game; they were issued options.  If management did not perform, the stock would not go up, and their options would be worthless.  Employees loved it, shareholders loved it, essentially everyone loved it; everyone except the few who really cared to understand what was happening.

The Enron, Qwest and World Com scandals were all created by fake accounting in an effort to make earnings per share (EPS) appear better than reality.  On Wall Street EPS drives stock prices, and the higher the earnings, the higher the stocks.  In the late 1990’s management teams began to manage Wall Street earnings expectations and eventually all companies would “beat the numbers” by a penny a share.  Beating Wall Street consensus EPS estimates became the norm and momentum investors bid up stocks to unrealistic valuations.  Options play a huge roll in managing EPS, because the use of stock options arbitrarily inflates operating income by underreporting human resource expenses.  Successful management teams were able to pay employees exorbitant amounts while at the same time keeping reported salaries level by aggressively using options.

Exploiting the Accounting

Due to the current accounting treatment of options, which will likely change by the end of 2004, companies are not required to count the cost of the options they issue as actual expenses.  Therefore, the expense of the option does not have to run through the income statement.  This has been a huge boon for technology companies who have been among the most egregious offenders of this practice. Essentially, the companies can pay employees in options while at the same time they do not have to record an expense – free money!

The convoluted reason options enjoy this accounting treatment, is that companies argue options are a non-cash expense, thus they should not be on the income statement.  Keeping expenses off the income statement is important to employees and managers trying to increase EPS in any way possible.  While technically granting employee options does not entail any immediate cash flow, the option does have value and eventually the grant will have a negative cash flow effect associated to its issuance.  The value of the options comes from its time premium, the amount of time between when the option is issued and when the employee exercises the option.  Usually this period is measured in years.

Companies further argue that expensing options on the income statement would be double counting.  Since options are already included in fully diluted shares outstanding many argue that expensing them on the income statement would be an unfair double whammy.  Finally companies maintain that options are too hard to value and cannot be measured accurately.  If that were the case, I would assert all the more reason to get rid of them.

In short, all of the arguments against expensing options do not hold water.  For years many legendary investors including Warren Buffett have crusaded against the current accounting treatment of stock options.  Last year many stock market Bears were able to draw media attention to options, citing them as one of the reasons current stock (especially technology companies) valuations are too rich.  In technology companies, the expense of options can account for nearly 50% of net income, and on average I have found that options account for 10% of net income in the quality companies I research daily.

The Shell Game – Follow the Cash

The great stock buyback program is the final piece of the puzzle.  For years investors cheered when management announced a company was buying back its stock.  Investors felt this was great news because shares outstanding would decrease thus increasing your individual ownership percentage of the company.  Plus the company was using free cash flow (FCF) efficiently by not paying out a dividend.  Remember dividends historically were taxed at ordinary income rates, and investors would rather get the full buying power of a dollar (through non-taxed buyback programs), versus 60% of the buying power from a taxable dividend.  Investors were hooked.  Stock buyback plans were welcomed with open arms.

Unfortunately, what really has been happening is more sinister than most investors realize.  The true cost of stock options can be found in most buy back programs.  The expense can be found on the cash flow statement, under cash flows from financing activities (funny it shows up on the cash flow statement when it’s not supposed to be cash flow).  Turns out management has been using share buybacks to offset the dilution caused by employee stock options.  Stated clearly, companies have been using FCF, which belongs to shareholders to buyback share dilution caused by employee stock options.  Thus, anywhere between 10% and 50% (in some cases higher) of net income belonging to shareholders, has been quietly wasted away on stock options.  That, my friends, is a transfer of capital to employees from shareholders.


I believe during 2004 the accounting protection for options will change and companies will have to pay for option abuses.  Earnings will go down and stocks will look more expensive.  Some technology stocks in particular could see net income cut in half.  With all of this taking place, companies that continue to feed at the option trough will likely be rewarded with lower valuations. At Perpetual Value I buy companies that are either already expensing options or are at least moving in that direction.  At the bare minimum, I take into account option dilution in my calculation of free cash flow.

Even if the market does not take the appropriate action by lowering the value of companies that abuse options, I still do not want to own a company that does not have our best interests at heart.  Remember as shareholders, we own a small piece of each business.  At Perpetual Value we think like business owners, and we won’t stand for or be fooled by the massive use of options to essentially steal shareholder capital.  Stop cheering share buyback programs and instead focus on a return of capital

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