Reckoning the Cost of Stock Options

Outstanding shares can be a drag on earnings

Although the stock of Yahoo! (YHOO ) is down 8% since CEO Terry Semel took the reins last May, the Internet portal recently handed Semel 1 million stock options on top of the 10 million he already owns. And why not? While Semel's $254,853 salary took a bite out of 2001's bottom line, the estimated $194 million value of his stock options--assuming the stock earns a 10% annual return--will never appear as an expense on the official income statement. In fact, because options "don't hit the income statement, corporations view them as free," says Elizabeth Fender, a director of corporate governance at TIAA-CREF, which manages $270 billion.

Since options require no cash outlays, companies argue the current accounting treatment is appropriate. Moreover, supporters say that by granting employees an ownership stake, options align the interests of shareholders and employees as no other form of compensation can.

However, in the wake of Enron's collapse, critics in Congress and at the International Accounting Standards Board, the industry's global rulemaking body, have introduced plans to count options against the bottom line. Businesses are lobbying against such a move, which would doubtless curb the huge awards critics blame for encouraging aggressive accounting.

Regardless of what happens to the accounting rules, shareholders should pay attention to the cost of options. That's why BusinessWeek is examining options accounting as part of a series, The Fine Print. Stock options give their holders the right to buy company stock at today's price in the future, usually within 10 years from the grant date. Say an employee has options to buy a stock for $10 when it's trading at $25. To exercise the options, the employee pays the company $10 a share, then can sell the stock on the open market for a profit of $15 a share.

While the employee makes out well, other shareholders do not. Exercised options turn into stock, which increases the number of shares outstanding. With earnings now spread over more shares, earnings-per-share declines, reducing the stockholders' slice of the pie. Companies with rapidly rising earnings might avoid this dilution. More often, though, corporate treasurers buy back stock on the open market to avoid issuing extra shares. If the company spends $25 for a share it sells to an employee for $10, there's a cash drain. The impact doesn't show up in the earnings statement, but it does hurt the cash balance.

Although companies don't have to treat options as an expense, they must disclose key details about their options programs--including restating the bottom line for the cost of options. To get the lowdown, flip to the footnote devoted to options in the annual report. The first table quantifies the number of options outstanding. Here, you can compare the size of the company's annual options grants in recent years.

In the case of Cisco Systems (CSCO ), Table 1 shows a growing reliance on options during a time of financial pressure. Grants rose from 245 million in fiscal year 1999 to 320 million in fiscal 2001. You can also find how many options were exercised and canceled, which usually occurs when employees leave. The bottom line for Cisco: The number of options outstanding is up from 876 million to 1.06 billion in just three years.

To be sure, many options issued during the bull market can only be exercised at prices far above the stock's current value. As a result, they are likely to expire worthless. Take the 320 million options Cisco granted in 2001, at an average strike price of $39.93. With Cisco's stock at $17, who would pay nearly $40?

But some of Cisco's options can be exercised at prices below even today's stock price. If you add the first two lines on the right side of Table 2, under "options exercisable," you find that 354 million options--a third of the 1.06 billion outstanding--are exercisable at prices below $17.

A glance to the left, under "options outstanding," reveals that yet more options sport strike prices below today's stock price. But many have yet to "vest," or become employees' property. Nearly all of the options in the first two lines of the table--a total of 481--can be profitably exercised. Subtract the 354 million that are now exercisable, and you get 127 million that have yet to vest. This table tells you there's a strong possibility shareholders may have to share their stakes with owners of an additional half-billion shares. So, Cisco's earnings will be spread over about 7% more shares.

Now, back to the heart of the options debate. What would be the effect on earnings if options were treated as an expense? The second line of Table 3 reveals that with options factored in, the company would have posted a $2.7 billion loss for the fiscal year ended last July 28. That's almost triple the $1 billion loss actually reported. To determine the year's options expense, subtract the pro forma earnings on the second line from the reporting earnings on the first. The difference is the options expense, which in Cisco's case climbed from $536 million in 1999 to $1.69 billion in 2001.

How does Cisco figure the options expense? Like most companies, it uses the Black-Scholes options pricing model. This estimates the fair value of the options granted that year based on the four assumptions in Table 4. The expected dividend and the risk-free rate, are straightforward. Since Cisco does not pay a dividend, that number is zero. Companies must use government bond yields as a proxy for the risk-free rate, says Janet Pegg, accounting analyst at Bear Stearns. For Cisco, it's 5.4%.

But attaching a value to the stock's expected volatility is an inexact science that leaves "room for manipulation," says Julia Grant, associate accounting professor at Case Western Reserve's Weatherhead School of Management. For example, one way to reduce options expense--and give pro forma earnings in Table 3 a lift--is to lower the expected volatility. Here's why: The less volatile a stock, the less likely it is to rise enough to make the option profitable to exercise. As a result, the option's value is reduced and so is its cost to the company. To get a sense for whether a company's assumed volatility is reasonable, look for rates that decline sharply or are out of whack with those of rivals. For Cisco, Sun Microsystems or IBM are good choices.

Only those options that vest in the current year are included in options expense. Typically, options vest in equal installments over several years, to give employees an incentive to stick around. What you can't tell from the footnote is how many options vest each year. You can guess by dividing past grants--under "granted and assumed" in Table 1--by the four- to five-year vesting period described in the text of Cisco's footnote. If you assume vesting occurs over five years, you can figure that 20%--or 49 million--of the 245 million options handed out in 1999 were in that year's options expense, with an equal number in each of the following four years.

With earnings depressed, companies are handing out a slew of new options to compensate employees, while conserving cash. So check in the footnotes--or risk a nasty surprise when the tidal wave of giveaways gets cashed in.

By Anne Tergesen

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