Arnold Kling

Stock Options and Earnings

Arnold Kling, Great Questions of Economics
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Hal Varian discusses the controversy over accounting for stock options.

Suppose you are the sole owner of a company worth $1 million, and you want to hire a chief executive. The candidate for the job says, "Give me half ownership, and I'll make your company twice as valuable." Even if this person succeeds in doing so, it would be a wash for you, since you would end up owning half a company worth $2 million.

This way of looking at stock options is to focus on dilution. The alternative, which I prefer, is to treat them as compensation.

To me, Varian's example sounds like a start-up phase company. It does not sound like a large public company. A large public company does not necessarily have to issue more shares in order to provide stock options. It could buy its stock in the market and sell it to executives who exercise options.

Supporters of the current accounting treatment for stock options argue that they are reflected in the reporting of diluted earnings per share. However, as Varian points out, investors are not encouraged to look at diluted earnings per share when they value companies. As he puts it,

much of the problem would go away if people paid attention to diluted earnings per share rather than basic earnings per share.

Earnings per share made sense before options compensation became widespread, but that time has long passed and the financial news media should recognize this change.

Stock option proponents say that stock options help to align the interests of investors and employees. However, there are other ways to do this, including stock grants and performance-based bonuses.

In fact, I believe that stock options are used not to ameliorate potential differences in perception between investors and employees but instead to exploit such differences. I believe that the whole idea of stock option compensation is to foster the illusion that a company is getting something for nothing.

Stock options are an attempt to obtain effort from employees without any cash outlay. For stock options to be preferable to cash, either employees have to value them more highly than cash or investors have to undervalue their cost relative to cash. I believe that the latter is the case, because of the failure to treat options as compensation in earnings statements. The desire to sustain this illusion is what makes the proponents of stock options go ballistic at the prospect of appropriate accounting treatment for them. Without the fiction that companies are getting something for nothing, stock options would lose their magic.

Discussion Question. Varian asks, "which definition of earnings per share is a better predictor of future stock prices: options-expensed earnings per share or diluted earnings per share?" Is that the right question?

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