Earnings: It's Still Apples And Oranges

After battling for more than 12 years, the Financial Accounting Standards Board has finally come to the moment of victory in its drive to see companies record expenses for stock options paid to employees. Over the next several weeks, most companies will start factoring options expenses into their quarterly earnings results.

But investors won't suddenly get clear visions of company profitability. Resistance among technology executives and the tech stock analysts who go along with them means the phase-in is far from complete. In fact, if anything, investors comparing corporate bottom lines this year will still be looking at apples and oranges, often without realizing it. The reason: A significant minority of companies and analysts still use earnings numbers that exclude or minimize options expense.

Companies have been phasing in the rule since June. The added expense will probably reduce earnings in the aggregate by about 3% for companies in the Standard & Poor's 500-stock index, accounting analyst David Zion of Credit Suisse Group (CSR ) estimated late last year using 2004 data, the most recent available. But the impact could be less than that because many companies in 2005 cut back on options grants or changed terms and estimates of their value to reduce the amount they'll have to report.

The clarity the change is supposed to bring has been muddied. At least 846 companies papered over their stock option costs before coming under the rule by vesting their options grants early, according to a report by accounting analyst Jack Ciesielski in The Analyst's Accounting Observer. The move effectively put into the past expenses that would otherwise be counted over the next few years. It will take roughly three years before that ploy plays out, says David Bianco, chief U.S. equity strategist at UBS Investment Research (UBS ). Until then, earnings for those companies will look better than those of competitors that didn't use the gimmick, all else being equal.

That is just one reason why comparing price-earnings ratios across companies is perilous. For nearly one-third of the stocks in the S&P 500, a majority of analysts still exclude options expense when calculating their profit estimates, according to earnings tracker Thomson First Call, which provides the estimates used by Yahoo! Finance (YHOO ) and other Web sites. The omission, which isn't usually flagged on free sites, makes shares of companies with a lot of stock options expense look cheaper than they really are. Shares of NVIDIA Corp. (NVDA ), for example, traded recently for about 20 times this year's analysts' estimates but 24 times estimates counting the options expense. Victory can't be declared by accounting regulators without those basic numbers in synch. Until that happens, confusion reigns. Investors without access to expensive information services will likely suffer disproportionately.

The good news? The stock market has already taken much of its hit for the cost of options in the five years since the Enron Corp. and tech-stock collapses put options accounting front and center on the reform agenda. The debacles prodded institutional investors in many stocks, but not all, to focus on the shareholder wealth employee options were spiriting away. "The market has been resetting gradually for stock option expense," says Bianco of UBS. "At this point, the vast majority of it is already priced in." Phew.

By David Henry

    Before it's here, it's on the Bloomberg Terminal.