VideoAfter all, options have little or no value when they're "out of the money"--that is, when the underlying stock's price is below the option's exercise price. Only when the stock rises above that exercise price can the option be converted to stock. But when the value of a company's stock rises above that level, in the words of one CFO, "everyone is happy." And the bull market has made for more and more such mutual joy.
But shareholders may not be so happy if they look at the footnotes buried at the bottom of some 1996 annual reports. Consider Westinghouse Electric Corp., as CBS Corp. was known until last year. Under a new rule imposed by the Financial Accounting Standards Board (FASB), Westinghouse disclosed that it would be forced to report a loss of $8 million in 1996, instead of net income of $30 million, were it to consider the cost of its employee options exposure. In other words, it would have taken 126.7 percent of Westinghouse's income to finance options granted to executives and other employees in 1996 and some of those that were granted earlier that could be exercised.
CBS shareholders are hardly alone. Other companies that would take big hits include software giant Microsoft Corp., which did more than any company to popularize stock options when it became evident a few years ago that scores of employees had become multimillionaires as a result of exercising their options. At the end of September, Microsoft reported that covering its total options exposure would eat up 30 percent of its annual earnings, based on the previous 12 months' numbers.
For such disclosures, FASB requires companies to use the so-called Black-Scholes model to determine fair value. But they need count only those options granted during the reporting period and those vesting during that time frame that were granted after December 15, 1995. Of course, companies can go further if they want. Microsoft says it also counts options that were granted earlier, as well as those that are not yet vested.
"Stock options are our largest financial obligation outstanding," says Greg Maffei, Microsoft's CFO. "They are an enormous part of how we motivate and retain employees."
Using Microsoft's approach, Sun Microsystems Inc. vice president of corporate resources, CFO, and chief information officer Michael Lehman estimates the expense of its options would absorb 10 percent to 20 percent of the Palo Alto, California, network computer products maker's annual earnings. According to a consulting firm that asked not to be identified, others whose 1996 annual reports show big hits include computer retailer Best Buy, where the cost of covering options would reduce net income of $1.7 million to a loss of $1.2 million, Goodyear Tire and Rubber (from a plus $101.7 million to a plus $91 million), Humana ($12 million to $4 million), Monsanto ($89 million to $79 million), and Texas Instruments ($385 million to $305 million).
Until now, options have been shrouded in market mystique, defended by corporate executives and employees alike, and largely ignored by analysts and investors. But the numbers suggest that stock options are not free, as many have claimed, but cost real money, and that may finally raise some eyebrows.
The big question, of course, is whether the cost is justified. While proponents claim options are necessary incentives, the grants have not only overstated corporate earnings, but have also added to dilution, forcing companies to spend cash to buy back shares--often at higher prices than the option's exercise price.
Finally, stock options may not be as effective an incentive as proponents have claimed. Some critics charge that options lure companies into risky ventures that temporarily boost the stock price. Indeed, several studies suggest that long-term stock performance at companies that pay executives in options doesn't match those where stock ownership by executives is the norm. So perhaps it is not surprising that the tax breaks companies get for stock options have come under attack in Congress.
What complicates the issue is that the cost of options is difficult to measure with any precision.
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Clearly, however, the impact of options extends beyond earnings. No one denies that they have created substantial--and rising--dilution. A 1997 study of executive compensation at the top 200 U.S. industrial and service corporations, conducted by Pearl Meyer & Partners Inc., an executive compensation consulting firm in New York, found that for the first time, over half the companies surveyed had more than 10 percent of total shares allocated for potential exercise of options.
A 1997 study by human-resources consulting firm Watson Wyatt Worldwide found the average overhang at 13 percent. And according to Pearl Meyer, 14 companies allocated more than 25 percent as of June 30, 1997, the latest numbers available (see table, above).
The combination of overstated earnings and dilution from currently exercisable options distorts actual earnings per share. As Thomas McManus, a Katonah, New York- based independent U.S. equity strategist, puts it, "Reported earnings are fantasyland compared to these real obligations."
But the yardstick may become marginally more accurate as a result of a different rule from FASB, which requires companies to shed more light on the impact of dilution. Previously, companies didn't have to report their EPS both with and without the effect of options, warrants, and certain convertible securities, if the difference amounted to less than 3 percent. Because FASB claims many companies failed to show both when they should have, it eliminated the 3 percent test starting last December 15.
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