Editore"s Note
Tilting at Windmills

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November 20, 2003
By: Kevin Drum

STOCK OPTIONS....Yesterday Howard Dean mentioned a desire to "re-regulate" companies, and one of his targets was businesses that offers stock options. I can't say for sure what he was talking about, but my best guess is that he was supporting the idea that stock options should count as expenses on a company's balance sheet.

Here's a very quick nutshell description of what this is all about. Typically, companies offer stock options to their employee at the current price of the stock, but the options don't "vest" for several years. For example, I might be offered 10,000 shares at an option price of $10, but I can't exercise the options until, say, 2007. At that point, if the stock is worth less than $10, I just walk away and do nothing. But if the stock is worth, say, $20, then I can exercise my right to buy the shares at $10 and then turn around and sell them immediately for $20.

This is obviously a pretty good deal: there's no downside and no risk, and a very good chance that the options will be worth a lot of money when they vest. Companies that offer their employees stock options can usually get away with paying lower salaries, and this in turn helps their bottom line: lower salaries mean lower expenses, which means higher profits, which means higher stock prices. It's a virtuous circle.

Except for one thing: stock options are not free. They seem free, since a company uses its own stock to cover the option grants, but this is a mirage. Stock options do have a cost, since the stock itself has a cost, but it's hard to calculate because the stock is not actually issued until several years after the options are granted. So the cost has to be estimated, and the most widely used method is a rocket-science formula called Black-Scholes.

It's estimated that companies like Microsoft, which rely heavily on stock options to compensate their employees, have overestimated their earnings over the years by as much as 30% because they didn't have to account for the cost of the options they were issuing. There are moves afoot to require companies to account properly for stock options, which would give a better estimate of their real earnings, but this is being fought tooth and nail by high tech companies that realize that a big part of their appeal is based on artificially inflated earnings.

Anyway, this is all a longwinded introduction to a couple of posts over at Begging to Differ that explain (1) how Intel is leading the fight against efforts to reform stock option accounting, and (2) how Congress is caving in to Intel's efforts.

Yes, this is an obscure issue. But it's one that goes to show how obscure accounting and corporate governance issues can have a real impact. How far do you think the tech bubble would have gotten if high tech earnings hadn't been inflated by stock options? Not nearly as far.

And how bad would the tech bust have been if the bubble hadn't been so big? Not nearly so bad. This stuff really does make a difference.

Kevin Drum 12:29 PM Permalink | Trackbacks

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