NCPA - National Center for Policy Analysis

How Stock Options Affect Corporate Profits

September 8, 1999

Federal Reserve Board Chairman Alan Greenspan recently discussed the problem of measuring corporate profits. The first issue Greenspan identified is the increasing use of stock options to compensate employees.

Options are not subtracted from current earnings as are ordinary wages and benefits. This makes profits appear larger than they actually are. Berkshire Hathaway Chairman Warren Buffett is concerned employee stock options dilute his equity without being properly accounted for. He and others believe that once investors become fully aware of this dilution many shares will appear overvalued, leading prices to fall sharply.

  • Outstanding options in the top 200 U.S. corporations were worth an estimated $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 -- for example, a study of Microsoft, the world's largest corporation based on market capitalization, found its 1998 profit of $4.5 billion would 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 a self- correcting mechanism with stock options as they affect share prices: the more options a company grants the less it pays out in dividends, reducing share prices. Money that would otherwise be used for dividends is used to repurchase shares for exercised options, which prevents dilution.

Another factor Greenspan mentioned that may be offsetting potential exaggeration of corporate profits is the tax treatment of software. Software is normally expensed by firms -- subtracted directly from earnings. However, much investment in software is really a capital expenditure. Economists Erik Brynjolfsson and Shinkyu Yang of the Massachusetts Institute of Technology (MIT) found that 90 percent of the investment in computers is not capitalized but expensed.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, September 8, 1999.

 

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