Stop Stressing About Stock Options

To expense or not expense? The markets will ultimately decide which is best.

February 19, 2014

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stress ballCompanies resent the GAAP requirement of expensing executive stock options – the rights granted to an employee to purchase a particular number of shares for a fixed price over a defined period of time enabling the employee to share in the company’s growth during the life of the option. They would prefer not to expense them – ignoring stock options would lower worker-related compensation expenses, as instead of paying an employee a high salary, a company offers a lower cash salary plus stock options, and thus increases current income.  The argument then goes that if companies do not expense employee stock options their value will be higher.

Management, especially that of technology and health care that are heavy users of stock options, thus would rather not expense stock options. And they try to convince investors that this is the right thing to do.

Twitter’s management, for example, in the recent prospectus suggested investors de-emphasize the GAAP reported loss of $134 million for the first nine months of 2013 and instead focus on a much lower loss calculated by not deducting stock option expenses.  Actually, Regulation G allows companies to report income without deducting stock option-related expenses as long as they report GAAP based net income at the same time.

A recent report showed that 56 technology companies out of the 69 companies included in the S&P 500 index and 45 healthcare companies out of 54 reported side-by-side GAAP and non-GAAP calculation of net income.

But are management concerns valid, and should investors care about whether companies expense stock options or not?

To answer this, we need to understand equity valuation.
The most popular method used to estimate economic value is the Free Cash Flows (FCF) method, known as the entity approach. The FCF method is founded on the principle that the value of an asset is the present value (PV) of the expected cash flows resulting from the use of the asset over its life discounted by the appropriate discount rate. For a going concern, the company’s life is assumed to extend to infinity. Equity value is then estimated by deducting all claims from the entity value.

Management teams believe that if no deduction from revenues is made to reflect the effect of options, net income and, by extension, FCFs will be higher and so will the value of the firm.

This is not true.

Expensing of stock options has no cash flow or tax implications, and so its inclusion or exclusion from the income statement has no impact on FCFs. Moreover, FCFs reflect the cash flows generated by the company that are available to all providers of the company’s capital. Stock option holders, by accepting a lower salary, can be considered one of the providers of capital. As stock option holders represent a liability to the current shareholders in the same way as current debt outstanding, the PV of their claim has to be deducted from the PV of the FCFs that accrue to all claimholders. When valuing equity, the current value of employee stock options is thus deducted from the PV of FCFs. Such options can be valued by using one of the popular option valuation models. Furthermore, by subtracting their market value from the value of the firm, we account for the dilutive effect of these options when exercised in the future.

Moreover, to be consistent with the treatment of employee stock options as a liability, the discount rate applied to the FCFs, which reflects the opportunity cost to all capital providers, in theory, should also include the cost of stock options. This raises the company’s cost of capital (i.e., the rate used to discount FCFs), further reducing the PV of FCFs (i.e., firm value) and equity value and, hence, current stock price.

As a result, due to the higher discount rate, the exclusion of option expenses from FCFs, and the deduction of the market value of stock options from entity value to determine the market value of equity and price per share, the effect of stock options on the value of equity is felt immediately.

The question of whether or not to expense employee stock options is not worth all the worrying from management and their advisers.

Markets, one way or another, account for them when they value a company and its equity.

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