Stock Option Accounting and Total Returns to Shareholders: Has the market already factored an expense into today’s stock prices?

Watson Wyatt - Research Report

Introduction

Employee stock option plans remain very controversial in the United States, and are becoming increasingly so around the world. There are many who challenge the efficacy of stock options, which have become a lightning rod for the criticism of executive pay. They also have played a role in the crisis in corporate governance and the decline in shareholder confidence. At the same time, Watson Wyatt's research shows that reasonable levels of stock options have served our companies and our economy well. Despite the positive effects of options, however, the likelihood of a first-ever accounting expense for stock options is increasing.

We base this prediction on several factors, including IASB's move in this direction and pressure for this change from three major audit firms, S&P and institutional investors. Further, as many as 200 major companies are now voluntarily expensing their stock option grants. The prevalent U.S. accounting treatment is to estimate an accounting cost for stock options and to disclose it in a footnote to the income statement. The expense itself is not subtracted as a cost from profits.

In March 2003, the FASB (the accounting rules board) announced its intention to study this issue, with the high likelihood of mandating an expense. Should companies, their boards and their investors panic over the possibility of this new expense, since actual reported costs will RISE, putting downward pressure on earnings and stock prices?

This dilemma poses two additional key questions for the boards and top managers of publicly-traded companies:

  1. Has the stock market already incorporated this disclosed expense into the company's stock price? If yes, this means stock prices should not react negatively to a voluntary or mandated actual expense for options, since the previously disclosed expense has been factored in.
  2. Are there substitutes or complements to stock options that have equal or lower accounting expense, but equal or greater motivational power?

This report primarily answers the first question and recommends some ways of answering the second. In summary, we find that the stock market has indeed already factored these costs into today's stock prices and therefore believe that stock prices will move minimally as a result of a required expense. Later in this paper, we discuss the strategy and policy implications. We begin by explaining our research approach and findings.

Efficient Market Hypothesis

Well-known in corporate finance, the Efficient Market Hypothesis (EMH) argues that all publicly available information about a company, however obtained - whether via the income statement or the footnotes - is incorporated into today's stock price. Some academic research supports the theory, using the footnote expense as an explanatory factor of stock price. Watson Wyatt explored this issue further.

We used the most recently available data on stock option expenses from the footnotes of 800 companies from the S&P 1500 (1) . Table 1 shows the median size of this expense at both absolute and per-employee levels.

Table 1
Stock Option Expenses Over Time (median)

1999 2000 2001
Option expense $7.5 Million $9.7 Million $11.8 Million
Option expense per employee $763 $881 $1,032

We expect the dramatic rise of recent years to continue for 2002 and begin to slow down thereafter.

(1) Source: This data has been provided as part of the S&P's Core Earnings calculations for the S&P's Compustat database.

Overall Findings

Following are our key findings.

In the current bear market, an increase in the stock option expense is associated with lower total returns to shareholders (TRS) as investors become highly concerned that the cumulative dilution from stock options could overwhelm the motivational effect on employee behavior.

Table 2
2001 Stock Option Expense and Total Returns to Shareholders (TRS)
(All figures are medians)

2001 Option Expense(3) 2001 Option Expense/ee Total Expense 2001 TRS 2002 TRS
Low $282 $5.0M 14.9% -4.0%
Medium $828 $14.8M 1.4% -10.4%
High $5,127 $25.7M -1.9% -17.9%
(Option expense adjusted for industry)

Firms that have increased their stock option expenses have subsequently had significantly lower shareholder returns. In fact, for the typical company, an increase in option expense is associated with more than a dollar for dollar reduction in market value.

Table 3
Change in Stock Option Expense (1999-2001) and Total Returns to Shareholders (TRS)

Change in Option Expense % change 2002 TRS
Low -16% -6.7%
Medium 69% -9.1%
High 227% -15.1%

One of the questions raised by the stock option expense issue is whether companies will reduce eligibility for grants as a tactic to reduce the total accounting expense. For example, some companies may sustain their grant levels for top executives while reducing the number of stock options granted to a broad employee population.

Our research and consulting experience have consistently shown that broader stock plan participation is correlated with superior financial performance. Our stock option expense analysis enables us to examine this issue as well. We find that companies with high levels of participation in stock option plans create greater shareholder value than companies with low participation. Balancing overall expense with broad eligibility therefore appears to be a worthwhile effort.

Over the last three years, for the options that are allocated to broad employee groups, an increase of one percentage point (i.e., from 78% of the options to 79%) is associated with a nearly one percent increase in the firm's market value. This is equal to an increase of nearly $15 million in market capitalization for the median firm in our sample.

Consistent with Other Studies
Studies by Goldman Sachs and Morgan Stanley conclude that the disclosed accounting expense is factored into today's stock prices. Morgan Stanley examined 104 voluntarily expensing companies and found that their stock prices rose slightly, if at all, after they announced they would be expensing. This is consistent with our findings that the footnote data is already in the stock prices with a negative relationship.

(2) In the bull market that ended in 2000, we found that high disclosed stock option accounting expense was positively (and significantly) correlated with shareholder returns. This might indicate that, in a bull market, shareholders saw the incentive effect of stock options dominating the cumulative dilution effect.
(3) All firms in Tables 2 and 3 are categorized as low, medium or high expense firms based on their stock option expense or change in stock option expense relative to the typical firm in their industry.

Implications

This research has the following important implications.

  1. Stock prices are not likely to adjust dramatically if an expense is mandated. We understand the importance of reported earnings, but there is reason to be sanguine about this issue.
  2. All companies should at least evaluate the possibility of expensing before being required to. There may be benefits.
  3. Even companies that choose not to voluntarily expense should consider changing their stock incentive plans now, even if the new plans have a higher current accounting expense than stock options only. As the market has already factored in an expense from stock options, this is not likely to hurt the stock price.
  4. Companies should consider keeping their stock plan eligibility as broad as possible.
  5. Since the disclosed expense is negatively related to stock price, there could be shareholder benefit from reducing the disclosed cost immediately. If companies develop plans that provide superior value to the employees (see next section) and have lower accounting and economic costs, a "win-win" could emerge.

Alternative Solutions
Watson Wyatt urges all companies to consider modifying their stock-based incentives in light of our and others' research. This modification could encompass several important areas:

We believe these issues can be strategically combined. Academic and other research indicates that, when employees value a stock option, they place a substantial discount on the Black-Scholes accounting cost that they incur. This occurs because employees tend to be risk-averse and non-diversified. For example, assume that 1,000 stock options at a $20 strike price have an accounting cost of $10,000. An employee might value these at only $5,000. These options could be replaced by 250 shares (not options) with a cost of $5,000 - equal to the employee valuation.

This research on value, combined with our findings on disclosed expense and the EMH, leads us to recommend the following: Explore plans that provide superior value for employees and lower total accounting cost, and do it now.

In this vein, many companies, including those that voluntarily expense options, are exploring alternatives to stock options such as:

Creating Stock Ownership via a Management Stock Purchase Plan (MSPP)

An MSPP is a cost-effective way to encourage stock ownership by allowing executives to purchase company stock (with matching shares) on a pretax basis from income that would otherwise be paid as base salary or bonus.

With respect to plan design, purchases can be mandatory or voluntary, or a combination depending on executive stock ownership levels, firm culture, and so on. Companies typically offer a 25 to 50 percent match, which appeals to executive and shareholders alike. Typical plan features include:

Eligibility - Limited to designated members of senior management.

Match - A 25 percent match on the fair market value on the date of purchase.

Mandatory Purchase - Participants could be required to use 25 percent of their bonus to purchase restricted stock.

Voluntary Purchase - Participants are usually allowed to make voluntary purchases beyond mandatory levels.

Restriction/Vesting - Purchases are usually restricted from sale for a period of three years.

The advantage of an MSPP to the employer is that restricted stock has predictable and controllable accounting costs. The extra cost is equal to the match at purchase, and it is spread over the restriction period. In addition, there are tax advantages to the employer.


 



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