Standard & Poor’s has announced that it will include option expenses when it calculates earnings for its U.S. indices, including the widely followed S&P 500. The new Standard & Poor’s policy will result in a 4.2 percent decrease in earnings for the S&P 500 in 2005 — and an 18 percent decrease for companies in the information technology sector — according to S&P.
This has been a controversial issue since the Financial Accounting Standards Board began considering stock-option expensing, which for most public companies took effect for periods beginning after June 15, 2005.
Earlier this year, Thomson Financial’s First Call — perhaps the most widely followed earnings estimating service — asserted that if a majority of analysts supplied earnings estimates without allowing for the expense of stock options, then First Call would highlight the unexpensed number. According to The Wall Street Journal, however, Thomson subsequently stated that it would provide two sets of earnings estimates: one that would include option costs and another that may not.
Several months ago, the Council of Institutional Investors urged Thomson and the research departments of investment banks to create a single, consistent policy to reflect stock option-related expenses in net earnings estimates. In August, the council sent letters to the heads of 31 research houses expressing support for policies including option expenses in estimates and valuation models. “There should be no doubt regarding the desire of long-term investors to have the cost of employee options represented in financial statements and earnings estimates,” stated Ted White, the council’s deputy director, in the letter.
In September, Merrill Lynch announced that its equity research analysts would include options and other equity-based compensation expense in their GAAP estimates (and their pro forma estimates, if different) as of the first quarterly reporting date for each company after September 30. The policy applies also to forward-looking quarterly and fiscal-year estimates, the company added. In addition, Merrill added that research reports would lay out the variance between estimates that included and that excluded equity-based compensation expense for at least the next two quarterly reporting periods after September 30.
“The ability to compare costs across company and sector levels is vital to the investing community,” said S&P equity analyst Howard Silverblatt, in a statement. “A consistent earnings methodology that builds upon accepted accounting standards and procedures is a vital component of investing. By including option expense in operating and as-reported earnings, Standard & Poor’s is contributing to a more transparent and informed investment environment.”
The ratings agency stated that based on 2004 fiscal data for the S&P 500, as-reported earnings would have been reduced by 4.4 percent if all options expenses had been factored in.
Standard & Poor’s noted that options expenses increasingly represent a much smaller but still significant component of earnings. S&P also pointed out that with the inclusion of options expenses, price-to-earnings ratios will be slightly elevated but will still remain under historical averages.