Stock option compensation expense

[widenthemoat]

I wanted to reach out to the board for some help on viewing stock option compensation. It's clear to me that stock options are an expense that need to be included in the income statement, however, a part of me believes that the true economic expense is not simply the fair value of the option using the black-scholes on grant date. Wouldn't the true expense be the intrinsic value of the stock options that were exercised during the period in question? If this is the case shouldn't GAAP stock option expense be added back to operating income and the intrinsic value of options exercised for the period be deducted in its place to get a better picture of economic reality?

 

Hopefully this question makes sense to you all and thanks in advance.

[tyska]

I think that most would agree that they are a huge cost to shareholders with the dilution factor. But how one would quantify that with a formula might be a little harder.

[widenthemoat]

Agreed. The logic above may be better understood by quoting Michael Burry from the MSN Money Articles below. I believe that at the time this quote was written stock option compensation was not expensed in the income statement which is why in my previous post I mentioned adding back stock compensation from the black-scholes in the income statement initially before deducting out the intrinsic value like Dr. Burry does.

 

And to be perfectly honest, Intel is much more difficult to tear apart than Cisco Systems (CSCO, news, msgs). The abuses are simply not as egregious. I'll give it a college try, however. One big number that stands out is the $23.2 billion that Intel has spent since 1990 buying back shares.Pretty impressive. Unfortunately, there is roughly the same number of shares, adjusted for splits, outstanding now as back then. In fact, there may be even a few tens of millions more shares. Was that entire $23.2 billion diluted out of existence by options programs and stock issuances for employees and management under the GAAP table? Almost. When the employee executes a $2 option and turns around to sell the stock at $30, the company gets that $2 plus a tax benefit, both of which are offset by dilution of the common shareholder. Over the last decade, Intel has realized about $8 billion in cash inflows from these options exercises and from the associated tax benefits. So if the share count stays about even over the decade, the absolute dollar amount of dilution to shareholders is roughly $23 billion minus $8 billion, which equals $15 billion.That $15 billion is only roughly one-third of the $46 billion in net income Intel reported from 1991-2000. Over the long-term, this is how much Intel's options compensation and stock compensation policies dilute shareholders, and hence a rule of thumb might be to dock Intel's reported earnings numbers by a about one-third when trying to figure out value. If Intel demonstrates a penchant for re-pricing -- a practice that is just sheer theft from shareholders, in my opinion -- then earnings get docked a lot more.

 

source: http://csinvesting.org/wp-content/uploads/2013/07/Michael-Burry-Case-Studies.pdf

[tyska]

-- a practice that is just sheer theft from shareholders, in my opinion -- then earnings get docked a lot more.

 

source: http://csinvesting.org/wp-content/uploads/2013/07/Michael-Burry-Case-Studies.pdf

 

That's pretty much how I view the practice. I have a stock that is doing that, Total Energy. They have been buying back shares like crazy the last few years with very little movement in either the share price or the share count. The sad part is that when I originally purchased the stock the management was not planning on using options very widely. I guess that greed over came any sense of honour.

 

[morningstar]

I wanted to reach out to the board for some help on viewing stock option compensation. It's clear to me that stock options are an expense that need to be included in the income statement, however, a part of me believes that the true economic expense is not simply the fair value of the option using the black-scholes on grant date. Wouldn't the true expense be the intrinsic value of the stock options that were exercised during the period in question? If this is the case shouldn't GAAP stock option expense be added back to operating income and the intrinsic value of options exercised for the period be deducted in its place to get a better picture of economic reality?

 

Hopefully this question makes sense to you all and thanks in advance.

 

I think the GAAP method is closer to economic reality than what you suggest - if you want to know about the current earnings of a company, the value of current period compensation is what you should deduct. If you think about it in reverse, this will make sense - if a company gave out options for 10% of its stock in 2009, but had none exercised b/c the stock was down 80%, your method would be coming up with stock compensation expense of zero for the year. If you don't like Black-Scholes you could use another model or other assumptions to adjust the valuation of option compensation, but the current GAAP treatment of stock comp expense seems pretty robust in my view.