Options may be too lucrative to be curbed just because of a little earnings dilution Investors may be misled, while recipients cash in

The Outlook

May 10, 1998|By Kevin L. McQuaid and Sean Somerville

Wall Street's unprecedented bull run throughout the 1990s has led companies to increasingly issue stock options as compensation, as a way to lure and retain executives and workers.

But stock options can not only hamper a company's earnings, they also can mislead potential investors, since existing accounting rules do not require companies to report options as labor expenses.

A recent study found that several companies -- including Coca-Cola Co. and Merrill Lynch & Co. -- would have had significantly reduced net income levels in 1996 if stock options were reported as a compensation expense.

Some critics -- including Berkshire Hathaway investment guru Warren Buffett -- complain that stock options allow companies to understate labor costs and overvalue earnings.

As awareness of the issue grows, and companies begin providing options for larger pools of employees, can the system continue? Or will potential earnings dilution force companies to pay employees with cash?

Howard Sherman

President, Institutional Shareholder Services, Bethesda

If you want to go back 10 years, when large institutional investors became active in corporate governance, they wanted the board and the management to have compensation at risk. The simplest way to do that is to issue stock options.

Initially, it was a positive trend. Now we're seeing perhaps too much of a good thing. The size of the grants to the management has just become enormous. That, combined with a historic bull market, has resulted in payoffs that are just mind-boggling.

I think it's an aberration. I don't think we're going to see these $100 million-plus awards continue. There are a number of problems associated with them.

As a general market trend, every year you see a higher and higher payoff, and it's becoming very dilutive to shareholder equity. One of the problems now is, how do you create incentives? How do you raise the hurdle? What's been going on is, they just get more options or the options are repriced.

Those are clear abuses of the system. What we are trying to advocate is that options be tied to the stock market or tied to a peer group, so that you're not paid for just showing up.

There are very few companies using these innovative types of devices. But I think we're going to see more and more of them.

John Ciesielski

President, R. G. Associates, Baltimore

The problem is, stock options aren't transparent in a company's financial statements. When a company gives stock options, they are giving something of value. And some companies are raising the value of their earnings per share as a result, because they aren't taking into account the cost of giving an option.

It's more prevalent today, because people want them and there's a booming stock market. Companies use the excuse in giving options that they have to because options align management with shareholder interests. But that's not really so. Shareholders have more risk and invest sweat equity to get their shares. Executives often get options for nothing.

The key problem right now is, there are a lot of pigs feeding at the trough that no one really knows about and it keeps getting swept under the financial rug. Eventually, the stock's value does get diluted.

The system will continue, at least for now, because there really isn't a downside to companies issuing them.

If the market is down, management asks the company to reprice their options to reflect the reality of the market at the time. Shareholders who bought stock can't do that. But as long as there is a perceived value in options, and executives can find them at one place or another, they'll go where they can get them and force other companies to follow.

But there's a greater awareness to the issue now, and so, sooner or later, something will occur and make this issue visible, and companies will be forced to back off.

David Leach

Managing director, Compensation Research Group, Pasadena, Calif.

It's difficult to measure the return on stock options. Part of the reason companies give options is because they consider their employees an investment. But it's hard to define the time frame from which they should be measured or the impact they have. Performance requirements make them all the more controversial.

But we're in a market-driven system, and Wall Street has done well over the past six years, and no one imagined that. Too, we're in a competitive labor market where stock options are a tool to attract key talent.

The system of giving stock options isn't going to change, because shareholders and institutions have taken a more active role than in the past, and shareholders appear willing to continue giving options so long as they're tied to performance.

Pub Date: 5/10/98

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