PALO ALTO, Calif. (CNN/Money) -
The great stock-option debate consumes Congress, maddens the media and irritates the individual investor.
The salaries companies pay employees are accounted for as expenses and detract from earnings. But employee stock options -- merely another form of compensation -- don't.
So should stock options be treated as normal compensation and expensed accordingly? Of course they should. That was easy. But it's also missing the point.
Expensing stock options, as Coca-Cola and a small group of other companies now say they will do, will lower reported earnings. That, however, amounts to just a bookkeeping change.
Where options absolutely do matter is in their dilutive effect. To understand what I'm talking about, consider the impact of options first on reported earnings and then on potential dilution at two huge companies, Coke and Microsoft.
Coke grabbed headlines for announcing it'll expense employee options going forward, a move that would have eliminated about 5 percent of Coke's 2001 earnings. Microsoft, which merely states the fair value of its options, but doesn't expense them, would have seen an earnings hit of about 30 percent. (See what the expense hit would be for other big companies.)
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RECENTLY BY ADAM LASHINSKY
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Fine, but that's just a matter of accounting. The more interesting figure is the so-called options overhang, or the potential dilution if all a company's outstanding employee stock options were exercised and sold. When that happens the shares outstanding increase, and all things being equal, the value of each previously held share goes down.
And you can find this information in every company's 10-K annual report by searching for the expression "stock options." In Coke's case the number is puny, just 6 percent. In Microsoft's case, its outstanding options represent 17 percent of the total shares outstanding. (The numbers look even worse if you include shares set aside for future options grants, an exercise Money magazine went through for 50 of the largest companies -- you can see the results here.)
Why is this such a big deal? Microsoft's market cap is $281 billion and there are roughly 5.4 billion shares outstanding, for a price per share on Wednesday of $52. In Microsoft's annual report from last year, you can learn that there are 898 million stock options outstanding. Assuming no variable changes in the business, the addition of all those shares will make each one worth less -- just $45.
The exercise gets scarier when you stray from the top of the heap. At Broadcom, a semiconductor maker, the ratio of options outstanding to shares outstanding is 40 percent. At Yahoo, it's 23 percent.
According to Yahoo's 10-K, however, the average weighted value of each option is $39.22, well above Wednesday's close of $14.26. Ah, you must be thinking, then there's no reason to be too concerned about dilution. Sorry. Fifty-four million of Yahoo's 137 million options outstanding have an average weighted exercise value of less than $13.08. That means it's a near certainty that all those shares -- 9 percent of Yahoo's total -- have been or will be exercised and added to the share count.
So remember, it's the dilution, not the bookkeeping, that really matters.
Adam Lashinsky is a senior writer for Fortune magazine. Send e-mail to Adam at adam_lashinsky@timeinc.com.
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