Now, thanks to General Electric, the options free lunch is in its final days. GE’s announcement last week that it will start subtracting options from its reported profits is a pivotal event, because GE is the country’s biggest company in terms of stock-market value, and its influence is immense. Coca-Cola started the current stampede with a surprise decision in mid-July to treat options as an expense. Before that, only a handful of firms did so. Now more than 30 companies from Ambac to Wachovia have joined the bandwagon. Recently adopted international accounting standards would have probably brought the free-options era to a close in a few years, but by stepping up now, companies look like good guys. “The world will eventually separate those who stepped up voluntarily from the 10 percent who were dragged into it,” says Warren Buffett, who for years has nagged companies to treat options as an expense, “and won’t buy stock in any of the 10 percent.”
Obviously, Coke et al. aren’t acting out of totally unselfish motives. In these scandal-ridden, bear-market days, with disgraced executives taking perp walks in handcuffs and others taking the Fifth Amendment in televised congressional hearings, companies want to be seen doing something to look like good guys. And to restore investors’ faith in their bookkeeping. GE has been under attack for opaque, opportunistic accounting. So it’s expensing options and forcing its top executives to hold stock rather than cashing in options profits. Stanley Works has given up its plan to duck U.S. taxes by opening a mail drop in Bermuda. PricewaterhouseCoopers’s PwC Consulting, which was also trying to play the Bermuda tax-dodge game, decided instead to sell itself to IBM.
Before we proceed, some disclosures. Buffett is on the board of NEWSWEEK’s owner, The Washington Post Company, which was right behind Coke in announcing plans to consider options an expense. And I own about $12,000 of stock in Buffett’s company, Berkshire Hathaway, through NEWSWEEK’s 401(k) plan.
Back to the main event. With options-accounting reform inevitable, let’s see what this change means. And why it’s not a magic cure for what ails the stock market.
An option gives an employee the right–but not the obligation–to buy stock at a fixed price for a fixed period, generally 10 years. That right is very valuable. Say you have an option to buy 1,000 shares of Coke at Friday’s closing price of $50.10. You’ve got the same profit potential as someone who shelled out $50,100 for the stock, but you don’t have to lay out any money and you don’t risk a loss if the price falls. Placing a value on this right gets a little esoteric. But with the right software and databases, you can use the widely accepted Black-Scholes options-pricing formula to come up with a reasonable guess.
Coke, influenced by the market-savvy Buffett, who’s on its board, has gone a step further. It will get bids on options for 10,000 Coke shares, then apply the per-share price to the 25 million or so options it grants annually. This gives Coke an idea of its true options cost: how much outsiders would pay for the options that Coke is giving away to employees.
Other companies will value options the same way they currently do in financial footnotes. Some are waiting to see what everyone else does. The only thing we can be sure of is that consultants are going to make lots of money issuing high-ball or low-ball option-cost numbers. That’s not perfect–but it’s sure better than pretending that options, which employees value highly, don’t cost employers anything. This accounting fantasy leads companies to give CEOs options rather than restricted stock, which counts as an expense. The options obsession contributes mightily to an atmosphere in which goosing the stock price is paramount.
Treating options as an expense won’t get the Dow back to 11,000 tomorrow, or the Nasdaq to 5000. It will restore some investor confidence–but won’t solve the problem of stock prices as a whole still being high, or foreign investors bailing out. Sure, it would be great if a mere accounting change could make all of us investors rich again. But that would be a free lunch. And we know those don’t exist. Don’t we?
