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Options Again

Who gets excited whenever the subject of stock option expensing comes up?

… oh, just me, eh?

Well, you should read this post from the Mises blog for another angle on the opportunity cost argument. I participated in the comments for a while and then decided to quit and start writing a post here instead.

The opportunity cost argument for expensing can be dismissed with a single hypothetical.

Opportunity costs presuppose viable alternatives. The claim is that companies suffer an opportunity cost when they grant stock options to employees because they could have sold them on the open market.

What if they couldn't?

Take two identical hypothetical companies and let's say the stockholders of one of them approved a stock plan that forbade the company from offering options on the open market. They could still grant them to employees, but the alternative is unavailable — and thus the opportunity cost vanishes. Should the accounting of these two companies be the same, or not?

In the comments of the Mises post, Michael lays out an interesting alternative to stock compensation. If a stock grant is reinterpreted as two transactions, a cash salary to the employee plus the employee's purchase of newly-issued shares for exactly the same amount of money, this would achieve the effect of expensing the stock while simultaneously not obscuring the company's net worth.

That's a perfectly sensible way to do the accounting, and I would agree with it, except for the fact that I want the accounting to reflect the reality. In fact there is only one transaction, a direct transfer of partial ownership from the existing stockholders to the employee. I am opposed to inventing two transactions — neither of which actually took place — to explain the transaction that did.

I'm perfectly comfortable with the result that a company can reduce its compensation expenses by granting stock options. I'm comfortable with it because it's the truth. The cost is borne by the stockholders, not by the company. Of course this could be abused to make the company's employees look cheaper than they "really" are, but this isn't an isolated problem. Revenue can be inflated by sham transactions, for example. Any intelligent investor will notice an option "abuse" when they look at the rate of dilution and/or stock buybacks.

The message to take away is that valuing a company is hard work. Concentrating on any one number — revenues, profits, assets — is a mistake. You must also consider the company's competitive environment and future products still in development, and many other things. Valuing a company cannot be simplified to the grade school level. Anyone who thinks it can be is wrong, and will have their expectations reset by the school of hard knocks if they don't come to their senses in time.

Tiny Island