Saturday, April 17, 2004

Expensing Options

Head equity analyst at Morningstar, Pat Dorsey, has an essay on why stock options should be "expensed." Citing the recent recommendation of the Financial Accounting Standards Board to expense options, Dorsey argues that they are payments of some value so they need to be accounted for on companies' financial statements, regardless of how imprecise assessments of their value might be. Dorsey makes the case for restricted stock as a cleaner way to pay employees and managers with ownership in a particular business.

Founded by Joe Mansueto after he graduated from business school at Chicago, Morningstar has set the standard for mutual fund analysis. No other enterprise has done more to enlighten the individual investor trying to gain entry to the capital markets through funds.

More recently, Morningstar has beefed up its equity analysis. Their approach, shaped by Warren Buffett, Benjamin Graham, and to a smaller extent Philip Fisher, is best explained in Dorsey's new book, The Five Rules for Successful Stock Investing: Morningstar's Guide to Building Wealth and Winning in the Market. Dorsey advocates finding companies with "wide moats" (companies that for one reason or another have some protection against competition -- what Buffett would call a "competitive advantage"), a large "return on equity," and cheap valuations as determined by doing a discounted cash flow analysis. Moreover, following Graham, Dorsey recommends that you only buy when the stock is at a discount to your estimate of its fair value based on your estimates of its future cash flows -- that's what Graham called having a "margin of safety." (Incidentally, "competitive advantages" are extremely rare and do not always last long when they do exist precisely because of the competitive nature of our economy; what's good for the consumer stinks for the investor.)

It's certainly obvious that analysts interested in pouring over the financial statments and tyring to ascertain a fair value of a company would be concerned with the absense of options on those statments.

Dorsey intimates that the kind of "fundamental analysis" he practices has its limits; not all companies -- especially very young ones without lots of historical data to examine -- are good candidates for analysis. This necessarily means missing the Microsofts of the world when they're in their infancy, if you practice this kind of analysis. (It also means missing the other internet companies that went bankrupt.) Most importantly and less mathematically, Dorsey (like Buffett) teaches you to think like an owner of a business -- which is precisely what you are when you own a share of stock. He forces you to ask, "what's this business worth and would I buy the entire enterprise if I could?" instead of asking if you can buy shares now and sell them to someone who will pay more for them tomorrow.

If all of this seems daunting, I suspect it should. Dorsey wants to encourage his readers, but his book shows the average individual investor who gets a tip at a cocktail party, looks at a chart, and maybe mulls over the P/E ratio that he doesn't know what he's doing. Fortunately, this is not an unhealthy lesson. Index funds anyone?

Routine Disclaimer: We do not give financial advice at Innocents Abroad; but with over 50% of American households owners of publicly traded equities and the recent corporate scandals, these topics seem timely and important in a larger, political sense.


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