I know this topic has been broached here before, and I always felt that Saul did a good job of explaining why it is fair to back out the employee stock option expense because it will show up in dilution. His argument being that to take the expense hit and then use the resulting diluted share count was essentially double booking the expense. Especially since employee stock options cost the company no cash whatsoever.
I always felt that made sense and it would somewhat relieve my concern with stock option packages as long as they weren’t outrageous.
But while reading a quarterly report where a company announced a stock repurchase program, it occurred to me that maybe that logic doesn’t work with buybacks. Or at least show why many people think they should be rightly expensed (Warren Buffet being one example).
Example: a company is making money and growing and gives out a large 3 year stock option program. In parallel, they announce a similarly sized stock buyback program. After three years, the earnings has continued to grow at a given rate. Because the stock option program and the stock buyback were equivalent, the earnings per share has grown at the same rate. No problem so far in that the options program did not hurt the earnings statement.
But what seems to have been missed is that the equity statement has taken a hit because of the share buyback. So in fact, the company’s earnings power has not been hurt (as has been pointed out in the past) but some amount of money has been siphoned off of the equity statement in the form of buybacks over the same time period. This is the shareholders money and essentially the reason you own stock in a company. In the most egregious cases, the equity transfer out could be all of the profits (or even more) that the company has made over the three years and yet it never shows up as an expense!
Since buybacks are not expensed but rather purchases of equity (rightly so), it doesn’t show up in the profit loss statement at all. They keep reporting greater profits (even per share profits), but these profits are not rolling down to the shareholders equity. All of a sudden this feels like a hidden loss of capital (if not an expense) and to me at least, explains why you need to expense the original options in some manner.
Now to be clear, stock option incentive programs have a lot of benefits and are not wrong per se. But this does, in my mind at least, fill a gap in my understanding.
Anybody see something I am missing?
Randy
Long time admirer of Saul, Warren Buffet, and this board.
PS: I will admit that ignoring employee stock options may be the right thing to do from a stock investor perspective because the actual cost may be lost on the overall markets and hence the stock price, if not true intrinsic value. Also if the stock option package is a one time thing, the earnings per share has grown and hence the stock value. But that does imply that you must not ignore them entirely.