July 17, 2002
From the desk of Mindles H. Dreck:Stock Option Update
Here's how Coca-Cola will avoid the problems I mentioned in my earlier post on valuation of employee option extrinsic value:
To determine the fair value of the stock options granted, the company intends to use quotations from independent financial institutions. The option value to be expensed will be based on the average of the firm quotations received from the financial institutions to buy or sell Coca-Cola shares under the identical terms of the stock options granted.
Happily, I can say this addresses my primary objection to the practice, although one worries about the "independence" of the dealers providing quotes that are strictly academic. This is a constructive market adaptation.
Valero Energy Corp. CEO William Greehey says options should be expensed only when the recipients immediately sell the underlying shares. If executives hold onto the underlying shares and sell only an amount to pay taxes on the exercise, the company shouldn't have to record an expense, he said.I'm sorry, the executive dilutes your earnings the minute he owns the stock. If that's an expense, it's an expense when he receives it, not when he acts on it. Even if you have reservations about the potential distortions about expensing options (as I do) this would distort the distortion. I suppose the idea here was to create an incentive for executives to hold the stock, but there's too much baggage.
UPDATE: Richard Bennett , Craig Schamp andIndepundit have also weighed in on this topic. In addition,Will Wagner weighs in in Idepundit's comments with the killer graf , highlighting the same problem I pointed out earlier:
First, Mr. Buffett, with breath freshness unknown, states that it is “nonsense” to suggest that options can be valued. However, he admits in the same paragraph, that a comparable pension expense, “is calculated under wildly varying assumptions, and CPAs regularly allow whatever assumption management picks.” If options valuation are calculated “under wildly varying assumptions”, this defeats the purpose of making the financial statements less manipulated by management.Posted by Mindles H. Dreck at July 17, 2002 9:51 AM | TrackBack | Technorati inbound links"); ?>
Not a bad idea by Coke. Perhaps they should actually sell such options on the open market just before each board meeting to establish value.
As to the timing of dilution, I think you can argue that earnings are diluted at any time from the creation of the option pool to the sale of stock by the optionee. That is just one reason why this whole discussion is so academic and detached from reality, like so much of what the CPAs create these days.
Does the executive own the stock if the stock is purchased with a note secured by the stock?
Posted by: Richard Heddleson on July 17, 2002 5:13 PM
Well, If I recall correctly, those offered Stock Options don't actually *have* the stock until they excersice that option. Wouldn't it be a better idea to expense it when they actually utilize that option, and just disclose the possible liability to the stockholders, when the options are awarded?
No, that idea isn't mine. Its allllll Lawrence Kudlow : p
Posted by: Nick M. on July 18, 2002 12:26 AMWhat liability to the Shareholders? When do the shareholders have to pay anybody? The entry upon exercise is an increase to cash (or notes receivable), i. e. assets, and an increase to Shareholders equity. Where's the liability? This is the problem I have with this entire debate, which is really demagougery.
Posted by: Richard Heddleson on July 18, 2002 1:05 AMI assume the "liability" is the foregone earnings. The shareholders "pay" it in the sense that any dilution is earnings they won't receive.
The trouble here, as I mentioned in the earlier post, that stock options swap a contingent claim on future earnings for cash or other current compensation today. Valuing a contingent claim on an uncertain cash flow is problematic, which seems obvious when you explain it that way.
Posted by: "Mindles H. Dreck" on July 18, 2002 9:31 AMStock options generally vest over a period of time. Thus, it could also be said they swap a contingent claim on future additions to shareholder wealth (which ought to be a function cash flows)for future labor. The commitment to supply the labor and the cost is known. Whether or not there will be future additions to shareholder wealth and whether or not the claim on such additions will be made are contingent and unknown.
Posted by: Richard Heddleson on July 18, 2002 11:30 AM"Does the executive own the stock if the stock is purchased with a note secured by the stock?"
Yes, unless it is a non-recourse loan. If not, he's liable for the loan, not the stock value.
Posted by: "Mindles H. Dreck" on July 18, 2002 10:23 PMI am a little confused by your answer. I believe you are saying he owns them if under a recourse loan but not under a non-recourse loan. So if the exec takes out a non-recourse loan to purchase the stock, the shares are exercised, votable, part of shares outstanding, taxable if NQ, subject to AMT if ISO, but not qualified for capital gains treatment for future gains and not expensed on the financial staterments? Good luck explaining that to the public after the demagogues print it up in the Times.
Posted by: Richard Heddleson on July 19, 2002 2:58 PMThe question made no reference to financial statement treatment. It just asked about whether stock bought with a loan is owned by the borrower/purchaser.
Stock purchased with a non-recourse loan is nearly identical to an option. If the stock goes underwater you walk away with no loss. If the stock returns exceed the loan interest you have a gain. The interest paid on the loan is your premium. the only difference might be the eligibility for dividends. That's why I say you don't own the stock.
As to explaining it to the public, or how it should be treated in financial statements, all the issues relevant to options are relevant to the non-recourse loan scenario (potential dilution, etc), as you point out.
Posted by: "Mindles H. Dreck" on July 19, 2002 5:02 PMComments are Closed.