The issuance of stock options by companies, specifically technology companies, is often overlooked by investors.
However, while these may not seem like a real cost, it is fundamentally a wealth transfer from shareholders to company employees (typically of the executive level). That's why these transfers need to be taken into account when evaluating certain enterprises.
'Corrupt' stock option accounting
In some respects, this style of accounting is underhand. Charlie Munger (Trades, Portfolio) once called stock option accounting "corrupt." It's clear to see why. Issuing stock options is a thinly disguised way of compensating executives and other high-level employees without declaring it is a cost.
Warren Buffett (Trades, Portfolio) described the problem with this approach in1999 at the Berkshire Hathaway annual meeting of shareholders:
"It's a compensation cost. And just try going to a company that's had a lot of options grants every year and tell them you're going to quit giving the options and pay people the same amount of money. They'll say, "You took away part of my earnings." And we say, if you've taken away part of the earnings, then let's show it in the income account and show it as a cost. Because it is a cost."
He went on to add that for this reason investors should always consider the impact options have on overall company profitability in the valuation process:
"We are going to — in evaluating a business, whether we're going to buy the entire business or whether we're going to buy part of it — we're going to figure out how much it's costing us to issue — and when the company issues those options every year. And if they reprice them, we're going to figure how much that particular policy costs us. And that is coming out of our pocket as investors. And I think people are quite foolish if they ignore that."
Finding an answer to the question of how much stock option compensation costs investors is not always easy. It requires time and effort. These figures can usually be found in SEC filings, which are not generally publicized by companies, and even in the filings, companies will often try their best to hide them through vague language.
There's more to this argument than just money. Many high flying companies rely on stock options to attract talent. That's not such a bad thing if the high flying business's share price continues to increase. If it doesn't, problems could begin to emerge. Potential employees are unlikely to want to accept options that might expire worthless over cold hard cash. This could make it harder for the company to hire new talent. Cash would be a substitute, but this would impact overall profitability. Struggling companies usually want to cut costs, not increase them.
The web of research
Understanding how a company uses stock options is just part of the massive web of data points investors need to understand before making an investment.
Some companies do you use this tool in a way that benefits all stakeholders. Others don't. It's not uncommon for companies to publicize earnings figures excluding stock option compensation, which provides a misleading picture of a firm's finances.
As well as providing misleading information, issuing stock instead of cold hard cash dilutes existing shareholders. If a company is repurchasing stock, the money is just going round and round. Rather than compensating employees in cash, the company issues stock and uses the cash from the company to repurchase the shares. In this situation, a business may be able to not only increase its bottom line but also pretend that it is only rewarding shareholders by repurchasing shares.
Unfortunately, the only people that will benefit in this scenario are the the employees and executives that are granted the stock options. Shareholders and other stakeholders may be left wanting.
That's not to say that these companies will not produce good returns. However, investors need to know what they are signing up for before they get involved to reduce the chances of an unnecessary surprise.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Warren Buffett on the Mindset Required to Be a Good Investor
- Warren Buffett's Advice on Finding Wealth and Fund Managers
- A Look at Costco Through the Eyes of Charlie Munger and Warren Buffett
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