Opinion Editorial | |
| Wednesday, September 8, 1999 | |
How Stock Options Affect Corporate Profits |
Headlines about a recent speech by Federal Reserve Board Chairman Alan Greenspan mainly focused on his discussion of using asset prices to guide monetary policy. However, a more significant and less reported element of that speech related to the question of measuring corporate profits. "The rapid shift in the composition of gross domestic product toward idea-based value added," Greenspan said, "is muddying our measures of current earnings and, hence, our projections of future earnings."
The first issue Greenspan identified is the increasing use of stock options to compensate employees. The problem is that options are not subtracted from current earnings as are ordinary wages and benefits. This has the effect of making profits appear larger than they actually are. As Berkshire Hathaway Chairman Warren Buffett recently complained, "In effect, accounting principles offer management a choice: Pay employees in one form and count the cost, or pay them in another form and ignore the cost. Small wonder then that the use of options has mushroomed."
As an investor, Buffett is concerned that his equity is being diluted by employee stock options without being properly accounted for. He and other observers believe that once investors become fully aware of this dilution many share prices will appear far overvalued, leading them to fall sharply. The Financial Accounting Standards Board, the body that establishes accounting conventions, has been wrestling for years with how best to account for stock options without success.
Unquestionably, the magnitude of options outstanding is huge and growing. It is estimated that in the top 200 U.S. corporations outstanding options were worth a staggering $1.1 trillion at the end of 1998, 13.2 percent of corporate equity. Each year, these corporations issue new options equal to 2 percent of outstanding equity.
The impact on profits is equally significant. A study of Microsoft, the world's largest corporation based on market capitalization, found that its 1998 profit of $4.5 billion would actually have been a loss of $18 billion had its stock options been treated as wage expense.
A study by the Federal Reserve, however, points out that there is a self-correcting mechanism with stock options as they affect share prices. The Fed study found that the more options a company grants the less it pays out in dividends, which reduces share prices. Money that would otherwise be used for dividends is used to repurchase shares for exercised options, which prevents dilution. Other studies have found that granting options to senior executives improves their performance, thereby raising profits and shareholder value. Ultimately, in a rational market, stock prices should already reflect the impact of stock options, causing them to be priced correctly.
Another factor that may be offsetting the potential exaggeration of corporate profits by stock options is the understatement of profits due to the tax treatment of software. In his speech, Mr. Greenspan noted that software is normally expensed by firms -- subtracted directly from earnings. However, in fact much investment in software is really a capital expenditure that should be written off over a number a years.
Greenspan believes that the expensing of software is artificially reducing reported profits. If it were capitalized instead, reported profits would be larger. A study by economists Erik Brynjolfsson and Shinkyu Yang at the Massachusetts Institute of Technology (MIT) found that 90 percent of the investment in computers is not capitalized but expensed. This may explain why financial markets place a $10 value on each $1 firms invest in computers.
Computers and stock options are clearly here to stay. Both affect profits and share prices. In the long run, markets will get it right. But in the short run, they may surprise unwary investors -- for good and for bad.
Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, September 8, 1999.
Alan Greenspan's speech may be found at http://www.bog.frb.fed.us/Board/Docs/Speeches/1999/19990827.htm
The Federal Reserve study may be found at http://www.bog.frb.fed.us/pubs/feds/1999/199923/199923pap.pdf
Warren Buffett's comments are from Berkshire Hathaway's latest annual report at http://www.berkshirehathaway.com/1998ar/1998ar.pdf
The MIT study is available at http://ccs.mit.edu/erik/itq
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