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expensing stock options

[I posted this in "Ask Joel," and decided to post it here to get more feedback.  If there are any finance nerds out there, read on and let me know what you think.]

There are two problems with expensing stock options:

(1) The "expense" will vary over time as the stock price changes
(2) The "value" of an option may have  nothing to do with the actual cost to shareholders.

Let's look at an example using Cisco's 2003 stock price:

Imagine that in January of 2003, when Cisco was trading around $15, Cisco granted 100 options to various employees with each option having a strike price of $30.  Let's say that these options expire in five years, that is these are January 2008 options, and they vest in two years.  Therefore, the employees would only be able to exercise between January 2005 and January 2008.

Using a Black-Scholes calculator and entering in some educated guesses on volatility and interest rates, we get back a "value" for each option of around $4.  Cool.  Cisco then subtracts $600 from its balance sheet as an options "expense."

So, here's where Cisco stands in January 2003:
stock price: $15
options granted: 100 (Jan 2008) with a strike price of $30
options "expense": $4 x 100 = $400

In January 2003, Cisco is showing an "expense" of $400 that hasn't actually occurred.  Cisco has not spent $400.  They have merely granted their employees some options that may or may not eventually be exercised that were "valued" at $400.

Now, let's fast forward to January 2004:
Cisco has rocketed to $25.  We run our Black-Scholes calculation again and find that the employee options are now valued at around $9.  Hooollly Jesus!  Does Cisco have to subtract another $500 from their balance sheet just because their stock price has gone up?  That seems insane.  And what if Cisco's stock price had went to $10 or $5.  They could add back income to their balance sheet.

All of this balance sheet chicanery would occur without any money changing hands.  And, if Cisco's stock price does not rise above $30 before January 2008, all of the options "expense" would have to be added back to the balance sheet because no actual expense would ever have occurred.

It's also important to note that in-the-money options that don't correspond to actual shares are included in the diluted earnings per share calculation.  Therefore, the expense would also need to be backed out once Cisco rises above $30, otherwise the "expense" would both subtract from the "e" (earnings) and add to the "p" (price) in the P/E.  It would count as a double-whammy against the corporation when it should at most be a single-whammy.

That pretty much covers point (1) above.  Now, let's examine point (2).

Why should investors even care about the "value" of employee stock options?  Answer, they don't, or at least they shouldn't.  Warren Buffett likes to argue that options should be expensed because the corporation is essentially giving away a benefit without showing an expense on the balance sheet.

It is true that options are a benefit and they may end up diluting the shareholder base, but it is also true that the options may end up costing shareholders nothing.  But notice, that in any event, the option will never actually "cost" the company money.  If the option is exercised, it will merely result in the issuance of more shares.  The result is a dilution of earnings, not an actual expense.

For example, a company with $10 in earnings and 100 shares priced at $1 each has a P/E of 10.  If this company then grants employees 10 options that are exercised, there will be 110 shares outstanding giving the company a P/E of 110/10 =  11.  This is the only way that options will affect a company.  There will never be an actual expense; there will just be some additional number of shares issued which results in diluted earnings and a higher P/E.

Because there  is no "expense" involved, what we need is not the Black-Scholes option valuing formula, but a formula that gives us a likely number of shares outstanding given the current number of out-of-the-money options outstanding using the present and historical stock prices  (in-the monies are already included on a 1-for-1 basis).

Let's see if we can come up with some type of formula that will do this for us.  What would this formula need to do?  Well, it needs to give us a percentage factor that we can multiple by the number of out-of-the-money options to give us a pro-rated number of shares outstanding.  If the formula spits out 50%, this would mean that there is a 50% chance that the options will eventually be exercised in the money.  So, if there were 100 out-of-the-monies outstanding, we would multiply by 50%, giving us 50 shares that we should add to the outstanding shareholder base. 

This formula would be very similar to the Black-Scholes formula, but instead of giving us an option value, it would give us a likelihood that the option would get to the money before it expires. 

I don't know much about the Black-Sholes model, so I don't know how to convert it to the type of formula I want, so for my purposes, I'll just use the option value as computed by Black-Scholes over the stock price to give me a factor that I will use in an example below.

We'll use Cisco again, and assume 1000 shares outstanding.

In January 2003 we have:
stock price: $15
shares outstanding: 1000
options granted: 100 (Jan 2008) with a strike price of $30
options "expense": $4 x 100 = $400
factor: 4/15 = 0.27

So, to get the pro-rated shares outstanding, we do the following:
1000 + (0.27)(100) = 1027.

Now, instead of a magical $400 expense on the balance sheet, we have increased the number of shares outstanding based on the likelihood that the outstanding options will eventually be exercised in-the-money.  This keeps unnecessary, confusing expenses off the balance sheet and puts the "cost" of the options where it may eventually end up:  expanding the number of shares outstanding.

Now, let's look at January 2004:
stock price: $25
shares outstanding: 1000
options granted: 100 (Jan 2008) with a strike price of $30
options "expense": $9 x 100 = $900
factor: 9/25 = 0.36
pro-rated shares outstanding: 1000 + (0.36)(100) = 1036

If Cisco had earnings of $100 in January 2003 and January 2004, we would get a diluted P/E of 1027/100 = 10.27 in January 2003 and a diluted P/E of 10.36 in 2004.  Under this scenario, options would still be "expensed," but the expense would show up where it belongs, in the P/E and in the diluted shareholder base, not on the balance sheet or income statement.

Sound reasonable?

dino
Saturday, April 10, 2004

Yaaaaaaaawwnnnnnnn!!!!!!!!

Have you seen the title of this forum? It says "Fog Creek Software"...  !!*SOFTWARE*!!

I couldn't care any less about stock options or expensing them...

I am suprised and disappointed Joel replied at all.

This forum is getting out of hand.

grunt
Saturday, April 10, 2004

I posted this in the other forum too. It is actually an interesting topic for software developers because, according to James DeLong, it's a useful way to reward intellectual property and the people who create it.

He says the move to expense options is actually politically motivated, and essentially represents an attack on staff.

http://cei.org/gencon/025,03055.cfm

In case you're wondering, I have no connection with DeLong. It's just that whenever I see allegations of political motivation in scenarios involving lots of money, I take an interest.


Saturday, April 10, 2004

Grunt, a quick lesson in forum lifetimes...
NewForum opens, and fairly quickly gains a crowd of people posting questions, learning on-topic stuff, etc.
As NewForum starts to mature, the initial rush of people settle downand enjoy helping new members of the community.
NewForum reaches its plateau. Now one of two things will happen:
1) The "old hands" will stick around to socialize, have conversations, ping new ideas off each other, etc. A nice side-effect is that they're also there to help out newbies and occasional visitors.
2) Someone (either the moderator, or the group itself) will generate some manner of excluding the horrific "off topic discussions." Because these people simply cannot manage a delete key (and by the way, this argument was dubious on mailing lists and CompuServe. When it's on a web based forum you really have zero excuse), they don't want anyone talking about anything except what they want to read.
Yes, read. Oddly enough, I've found that with a few exceptions, often the loudest voices about signal/noise are people who don't post.
Anyway, they put a forum gestapo in place. Net result - since the "old hands" can't talk about what they want to talk about, and have no interest in the FAQ's (which are all that are now on topic), they leave. So you end up with a boring tech assist forum full of churn. It might be an okay place to go to ask "how do I connect my web page to a database" but you'll rarely get a full response to "what is the best way to design my application."

I tend to favor the former, and have seen a lot of good communities destroyed by the latter. If you don't want to read about stock options, here's a thought - don't click on that link.

Philo

Philo
Saturday, April 10, 2004

BTW, I've got this '99 Ford Taurus thats making a klunking noise when you turn left. You guys have any idea whats causing this.

TIA,
AC

anon-y-mous cow-ard
Saturday, April 10, 2004

Physics.

Simon Lucy
Saturday, April 10, 2004

Philo,

I have the right to express my thoughts and feelings as much as you and the poster of this thread. I do not like or want to be on the sidelines as you suggested if I don't like something.

As a matter of fact, what you suggested is the very problem of this country (USA in this case). People say they dislike (or hate) this and that, but when time comes to *show* it (i.e. vote), there is noone around to say anything. That kinda crowd is doomed and deserves to get whatever it is they are complaining about.

grunt
Saturday, April 10, 2004

Grunt, where did I say you couldn't express your opinion? You said what you thought, I disagreed and explained why.

Philo

Philo
Saturday, April 10, 2004

> I've got this '99 Ford Taurus thats making a klunking noise when you turn left. You guys have any idea whats causing this.

Yes. Try examing the rubber sleeves over the suspension arm. On our car, it became cut by road debris, letting water and dirt into the steering arm.


Saturday, April 10, 2004

Back on topic...

I'm not enough of a finance nerd to comment on the details of your post, but companies need some type of cost for options.  While options may have been trumpeted as a way to spread the wealth among the staff, they've been used excessively as part of CEO compensation. 

While not the only reason, stock options have been a significant incentive for aggressive managing of earnings (and manipulation of stock price) in some of the worst financial scandals of the last few years.  It's clear to me that the ability to issue options without any cost has led to their overuse.

On the other hand, the downside of expensing stock options occurs in private companies without any liquid market for stock.  Their, options are "if we go public" bets designed to encourage employees to grow and reward them when they are successful.  (although the notion that an IPO=success can be rather dubious).  Creating an artificial cost for stock options assigns a real value for paper money that may just not make sense.

Will
Sunday, April 11, 2004

I don't necessarily agree that expensing stock options is a good idea, or that Black-Scholes is the right way to value options even if so. (Frankly I don't understand the issue well enough, and I do worry about the effect it would have on startup companies.) But I do want to comment on what seem to me to be mistaken assumptions in the original post.

"All of this balance sheet chicanery would occur without any money changing hands."

That's kinda how accrual accounting works under normal circumstances anyway. If you sell a product in July but your customer doesn't pay you until January, you book the revenue in July, even though you didn't get any cash until the following year. Or take depreciation, where you spend a bunch of money on an asset but spread the expense over a number of years for accounting purposes.

"For example, a company with $10 in earnings and 100 shares priced at $1 each has a P/E of 10.  If this company then grants employees 10 options that are exercised, there will be 110 shares outstanding giving the company a P/E of 110/10 =  11.  This is the only way that options will affect a company.  There will never be an actual expense; there will just be some additional number of shares issued which results in diluted earnings and a higher P/E."

All things being equal, you'd expect the issuance of 10% more stock to reduce the stock price by about 10%. Otherwise companies would have discovered the financial equivalent of a perpetual-motion machine: We're worth $1 billion today, but if we do a 2:1 stock split, we'll suddenly be worth $2 billion! Sorry, when you double the amount of stock outstanding, you halve the price per share. P/E is a derived measure that stays constant because both price and earnings have changed by the same factor.

And while dilution may not cost the "company" anything, it certainly costs the *shareholders*, because their stakes are now worth less than they were.

John C.
Sunday, April 11, 2004

Of course they have to keep updating the expense account as the stock price changes and the Black-Scholes equation changes.

It's called "Mark-to-Market", and it's what a company has to do for their liquid securities anyway.

Ankur
Sunday, April 11, 2004

"That's kinda how accrual accounting works under normal circumstances anyway..."

Kind of, but not really.  Booking revenue before the company actually receives it and depreciation both involve transactions that have already occurred.  The company has either contracted to receive payment or has bought something and is spreading out the cost.

Option grants only involve potential transactions and the company will not actually spend any money if the option is exercised. 

"Sorry, when you double the amount of stock outstanding, you halve the price per share. P/E is a derived measure that stays constant because both price and earnings have changed by the same factor."

Option grants do not involve the actual issuance of shares.  Therefore, the granting of an option will not affect the supply and demand for the stock in the market.  That is why the "expense" of an option grant is best measured by a derived measure like P/E.  Granting an option (especially an out-of-the-money option) is not the same as issuing shares.  Thus, an equation that computes the "expected" number of shares outstanding given the current stock price and stock price history that could be used to compute an "expected" P/E would best measure the hit shareholders might take if the options were ever exercised.

"It's called "Mark-to-Market", and it's what a company has to do for their liquid securities anyway. "

Securities owned by a company have an easily measured value based on their current price in the market.  Stock options (which may never be exercised) cannot be easily valued, and in any event will end up costing the company nothing, so there should not be an expense for them on the balance sheet.

dino
Sunday, April 11, 2004

> ... If you don't want to read about stock options, here's a
> thought - don't click on that link.
>
> Philo

What you said above, namely ignoring a thread that I feel strongly against, suggests that I shouldn't express my feelings and thoughts about it. Ignoring is not something I do as I mentioned earlier (read above). If you want me to ignore it, then don't post it (you or anyone else).

Don't you understand the meaning of things you are writing, Philo??

grunt
Monday, April 12, 2004

Oh.. I forgot to mention one other thing.  Thanks for the "quick lesson in forum lifetimes", but next time, just save yourself some time and keep it to yourself. I don't need your snooty stories.

grunt
Monday, April 12, 2004

<warning attrib="extremely offtopic">

dino,

How about making employee stock options exchange tradeable? That would be a very straightforward way to obtain a price for them. Sorry, just trying to think out of the box...

If you want to see more share-dilution shenanigans, there's an interesting story on Yahoo!Finance today about Mandalay Resorts and their issuance of convertible bonds...

Rob VH
Monday, April 12, 2004

Exchange-traded means that an Exchange chooses
to back your derivatives with their money. You or
your company don't get to make an option
Exchange-traded. That's the Exchange's power
and their decision. If an Exchange doesn't want to,
you'll just have to have an illiquid option, or trade
it on the NASDAQ (which is not an Exchange, and
won't back your option).

Curious
Tuesday, April 13, 2004

Sorry, I spoke poorly. I should have just said "tradeable". Most employee stock options are not tradeable, they must be excercised or expire worthless. That's the point I was trying to make.

The exchange doesn't back a listed option entirely with its own money, though. That's what margin is for.

Rob VH
Tuesday, April 13, 2004

Has anyone seen an article that shows a USA study of  the stock price change in companies  that have declared an expence for stock options?  I belive that it  showed no material change in price.  Please email me asap if you know this article.

Regarding my thoughts on this.  Apart form the fact that the study I refer to above negates what is happening (apart from a lot of consultants making $$$$$) what are we trying to achieve with this change.  The object of the exercise is to better inform shareholders and potential investors in regard the remuneration costs of the company.  Is messing with the PnL based on a theoretical pricing model that has asumptions like unlimited liquidity and no transaction costs achieving these aims?

Shareholders and potential investors would be better informed  if the notes to the accounts included not only reference to the executive remuneration and option holdings but say a payoff diagram for one executive option and say one share.  I believe that this information would enable shareholders to better assess the value added from such remuneration structures.

O Thomas
Friday, May 07, 2004

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