Tuesday, May 04, 2004

Options, Take Two

I received a very thoughtful letter about my piece on stock options. The writer argued that the proposition that stock values are based on future cash flow is correct but has nothing to do with options which, if expensed, would appear on the income statement and not the cash flow statement. Options are a non-cash expense, and, therefore, do not affect the fundamental value of the enterprise if one is using a discounted cash flow analysis to determine the intrinsic value. The writer also argued that the purpose of financial statements is to track corporate performance and not shareholder expense which is what options amount to. Golbitz, incidentally, also keeps telling me that although he prefers restricted stock, he hasn't come up against a good argument for expensing options. He simply doesn't know how it would be done as a practical matter if they were out of the money. Golbitz also comes close to saying that options are not a corporate expense -- at least not an easily quantifiable one.

First of all, I am happy to get such thoughtful criticism. Although I'm interested in these things, I am really just starting to learn about them.

I have replied to the writer that although options do not affect the value of the enterprise (because they are not a cash expense), they potentially diminish the value of the shares which represent less of a claim on the future cash flows as more shares get issued. Options, when exercised, dilute the stock, taking real wealth out of shareholders' pockets. The writer replied to this that it is not the purpose of financial statements to account for shareholder expenses, only "corporate performance." This argument, in my opinion, separates things that ought to be kept together. A corporation, as I understand it, takes in capital from shareholders (and creditors or note-holders) and tries to produce a return on it. Therefore, it makes no sense to speak of "corporate performance" without accounting for the return produced for the shareholders. Options do not destroy the value of a company, it is true; but they take money out of shareholders' pockets and put it into the pockets of managers. The fact that there is no loss of value to the company does not mean that the company is working well for its shareholders. Whether the company is unhealthy "organically" and has to burn through cash to keep itself going or whether it "redistributes" the cash it produces away from the shareholders and into the managers' pockets through dilution, it is not functioning well from the shareholders' or owners' perspective which is really the crucial perspective. At a certain point there is no difference between a company that is bleeding cash or one that is robbing its shareholders of it; those with the latter malady often contract the former.


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