Option expensing has arrived

Cite this Article
Bill Sjostrom, Option expensing has arrived, Truth on the Market (April 24, 2006), https://truthonthemarket.com/2006/04/24/option-expensing-has-arrived/

Under SEC rules, a public company is required to start expensing options commencing with its quarter one 10-Q for its fiscal year beginning after June 15, 2005. This means the time has arrived for public companies with calendar year-ends, and as a result, this month many companies have reported or will be reporting for the first time numbers that reflect option expensing. In a January post on the subject (here, and discussed by Geoff here), Rich Booth noted as follows:

In the end, it might not matter whether a company treats the grant of options as an expense. Studies show that a company’s choice of accounting convention makes no difference as to stock price. As it is, analysts can translate earnings into cash flow, while CFOs can explain away the aberrant effects of accounting rules by calculating pro forma earnings.

Based on this article in today’s W$J, however, this may not be true with respect to option expensing, at least in the short term. According to the article:

All companies that award options are affected equally, but the impact of options costs isn’t yet uniformly reflected in Wall Street’s earnings forecasts, which are widely tracked by many investors. So as investors suddenly see some of their favorite companies’ projected earnings slip because of the cost of options while others don’t, they may rush to sell stocks.

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Nothing changes materially for a company when analysts alter their estimates to reflect options expenses, but the way the share prices have reacted to estimate changes suggests that investor perceptions can take a hit. A Credit Suisse analysis finds when estimates have been adjusted for options expenses, those companies’ shares have tended to do worse than the overall market. This has been especially pronounced at companies whose estimates have been pushed down more than 5% by the inclusion of the cost.

One reason the estimate changes have pressured share prices is that many investors use estimate revisions as a stock-picking tool — if analysts’ estimates are rising, they buy, and if the estimates are falling, the investors sell. Companies also suddenly appear more expensive, because their price-to-earnings multiples, based on expected earnings, shoot up.

What is striking is that this options effect has persisted even though Wall Street firms started documenting how estimate changes were hurting share prices as early as October. “People should know about this stuff,” says Michelle Clayman, chief investment officer at New York money manager New Amsterdam Partners. “If numbers come down just because of options, they shouldn’t overreact.”