Bill Gurley On Restricted Stock
Bill Gurley's most recent Above The Crowd discusses the stock option expensing issue with a great analysis of Microsoft's recent decision to shift from stock options to restricted stock grants. He also details the other issues Microsoft faced in making the decision (lots of cash and lots of margin) and in the end comes to a conclusion we wholeheartedly endorse:
Should stock options or restricted stock be expensed? The answer to the question is an easy one: it doesn't matter. Stock prices, just like any other financial asset, are valued according to the predicted future cash flows discounted back through time, as appropriate for risk. In fiscal 2003, Microsoft generated nearly $16B in operating cash flow and will likely do more than that in fiscal 2004. Neither the choice of equity compensation nor any decision to recognize such offering as a GAAP expense will have any measurable impact on this cash flow. New grants of either options or restricted stock will represent future dilution, and the company will need to earn a return above and beyond that dilution in order to generate value for shareholders.Mutual fund managers understand this; they have understood it for some time, and they adjust for it in their calculations. To suggest that a mathematical non-cash accounting change will affect future stock prices, especially when the exact numbers have been available to shareholders for many years, drastically underestimates the collective intelligence of the stock market. Smart investors have already accounted for this future dilution, regardless of the actions of the FASB, and therefore these future grants are already reflected in stock prices.
Thank you! I have been puzzling over the issue for a while, and could not figure out why this is something that just would not be priced in by "smart money", and short-term and day traders only care about the direction, not the actual NPV of the cash flows.
On the other hand, while some priced the dilution in, estimated EPS did not reflect the already allotted dilution of the options thus making the term - EPS - much more ambiguous. After all two companies with identical EPS and identical cashflows would have widely different EPS if one has another 20% of its equity parceled out as options among employees while the other one does not. I thought options were a zero-sum game, and the writer (in this case the company) is left to pick up the tab for in-the-money options. Would not that severely affect a company's cashflow , especially if a significant portion of the option holders were to cash in at the same time?
Actually, it's easy to go a step further: anybody arguing against expensing them is unwittingly arguing for expensing them. After all, the argument against expensing them is that revealing their numbers directly in the financials would provide a disincentive for corporations to grant options. In other words, the only reason to grant them is because they can be hidden from investors, so the stock price will remain higher.
Bill's argument (and by extension Andrew's) is that efficient markets see through this.
The easy answer is: of course they should be expensed. Efficient market people like Gurley and Anker will not care. Inefficient market people are unwittingly making the argument for the other side -- so in essence, everybody is in agreement that it either doesn't matter or helps investors get more informatoin to expense the options.
There is only one possible argument against expensing them that doesn't automatically undercut itself. Specifically, their impact on the amount and timing of taxes paid by the corporation...but that's for another day.
-- Tubby
I think the issue is really moot for a couple of reasons. First of all, I agree with you guys that good fund managers and savvy investors factor in stock option grants. As long as the information is there, it doesn't matter whether or not they are expensed. A good analyst looks at more than net income.
On the other side, you have people who do technical trading, or people who trade online based on EPS numbers. These people are more concerned with earnings vs. earnings estimates, or charts and trends, so other than a brief blip when the accounting changes, in the long term it will have no effect on these traders either.
There aren't very many people out there (at least I hope not) who trade thinking that the a pro forma earnings announcement is an accurate reflection of company earnings.
"Would not that severely affect a company's cashflow , especially if a significant portion of the option holders were to cash in at the same time?"
Employee Stock options issued by the employer corporation are always cash flow positive to the issuer.
On issue the corporation spends no cash, other than administrative and compliance costs. On exercise the issuer recieves the strike price and a tax deduction for the compensation expense.
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I agree with the parent post. The only real issue created by stock compensation plans is the amount and timing of the dilution. bookeeping it really cannot make a difference.