FREDERIC W. COOK & CO., INC.
90 PARK AVENUE, NEW YORK, N.Y. 10016
NEW YORK · CHICAGO · LOS ANGELES

July 6, 1998

By Michael A. Thompson and Frederic W. Cook

Much has been written in the past few years regarding executive compensation. In recent months, however, the press has been filled with articles about executive stock options, with quotes from studies that claim that there would be exorbitant impacts on companies’ earnings if the true effect of stock options were required to be included in the income statement. Attachment 1 provides a partial list of selected articles in this vein.

The Financial Accounting Standards Board (FASB) made changes last year that clearly show the effect of stock option gains on the financial position of a company. Statement of Financial Accounting Standards No. 128 (SFAS 128) requires that each company report both Basic and Diluted Earnings Per Share (EPS). Basic EPS reports earnings as if no stock options are outstanding. Diluted EPS reports earnings assuming all outstanding in-the-money options are exercised (and any other security convertible into common equity is converted). Footnotes in most companies’ annual reports clearly allow a reader to determine the amount of dilution related to stock options and other equity awards separately from that related to convertible securities. It should be noted that this methodology assumes that all exercise proceeds and tax benefits are used to repurchase shares, and it does not consider the additional dilution that will occur if the market value of the company increases further or if additional options are granted as authorized under shareholder-approved plans.

How will that dilutive effect of stock options on reported EPS affect shareholders? The answer is simple. Most market analysts agree that it is Diluted EPS, not Basic EPS, that drives shareholder value. The total market value of a company’s shares at any point in time is a constant. It is the result of multiplying fair market value per share by total diluted shares outstanding. If there were a greater or lesser number of diluted shares outstanding at that point in time, it is market value per share, not total market value, which would change. Thus the cost of stock options to stockholders is measured by the difference between actual market value per share, and the per share market value that would exist if there were no stock options outstanding.

In our research based on the differences in Diluted and Basic EPS, the median shareholder dilution from stock plans is only 1.35%. In fact the most dilutive company is only 7.03%, and fully 75% of the companies have dilution of approximately 2% or lower. The remainder of this letter will summarize our research and the methodology we used to identify the true cost of stock options.

We reviewed annual report disclosure of 105 companies included in the 500 largest market capitalization companies reported in Business Week in March 1998 (companies for which 1997 annual reports were readily available at the time the research was completed). As shown in the table below, these companies had 12/31/97 market capitalization ranging from $5 billion to $245 billion. We excluded companies reporting net losses because these companies do not calculate a separate Diluted EPS number (the calculation is anti-dilutive).

In determining the cost of employee stock options, we focused on the difference between Basic EPS and Diluted EPS for 1997 resulting from outstanding stock options or other equity-based awards. The earnings per share calculation is a ratio that has a numerator (net income) and a denominator (number of shares outstanding). The true cost of stock options is not a reduction in earnings (the numerator) as some studies have suggested, because they are equity awards that have a balance sheet, not an income statement, effect. The true cost of stock options arises from the increase in common share equivalents outstanding, and related reduction in EPS and stock price, that occurs when a company has stock options that are potentially exercisable at a profit. This dilution is measured by the reporting requirements of SFAS 128.

Diluted EPS calculates the impact of outstanding stock options, among other things, on the average number of common shares outstanding. It does this using the "modified treasury stock method." As stated earlier, the additional number of shares outstanding under this method assumes that all outstanding options are exercised, that the amount the executive paid to exercise the option is used to repurchase shares of stock, and that any tax benefit the company derives from the option exercise is also used to repurchase shares of stock. Thus, the additional number of shares considered to be outstanding is something less than the actual number of options that are outstanding. The more "in-the-money" the option is, the higher the dilutive effect using the modified treasury stock calculation. This essentially looks at the issuance of stock due to outstanding stock options in the same way shareholders would look at a company issuing new shares to the public. The "cost" at any point in time is the amount less than current fair market value the company would receive upon issuing the shares. With stock options, this cost to stockholders is the same as the after-tax gain to employees if the options were exercised.

To measure the dilutive effect on market value, we calculated the difference in market capitalization per share based on the difference between shares outstanding for Basic EPS and Diluted EPS. In determining the shares outstanding for Diluted EPS, we only included those shares associated with compensation-related programs, such as stock options or stock incentive plans. We did not include shares associated with convertible preferred stock or other such equity-based financing mechanisms. The following shows an example of this calculation:

Attachment 2 shows the dilution calculation for each of the companies in our study, sorted in alphabetical order by company.

As stated earlier, the shareholders of the vast majority of companies in our study experienced dilution of 2% or less from stock plans. The following chart shows the breakdown of the dilutive effect of stock options. In fact, only 2% of the companies in this study experienced dilution of 5.0% or greater. Seven of the companies (6.7%) reported no dilution at all, though four of these are electric utilities, one of which doesn’t yet grant options, and another of which just recently began granting stock options. Only two companies known to regularly grant options (Airtouch and Kellogg) disclosed that the effect was immaterial, and thus reported that Basic and Diluted EPS were the same. In many cases, these statistics also include broad-based stock option grants covering large numbers of employees, or discounted stock purchase plans available to all employees. Admittedly, smaller high-tech companies in which options are more extensively used are not represented in this study.

The dilutive effect of stock options on EPS and hence on stock price is a function of two numbers: the number of option shares outstanding in relation to total shares outstanding (the option "overhang") and the per share appreciation in valuable options. Two companies could have the same 2% dilution. One might get there by a moderate number of options outstanding and a high option appreciation (favorable result); the other gets there by a large number of options outstanding and a low option appreciation (less favorable result). Low dilution per se is not necessarily favorable; nor is high dilution necessarily unfavorable. It depends on the reason dilution is low or high.

This analysis demonstrates that, despite the significant number of options being granted to executives and other employees, the true effect on shareholders is well below levels described in some recent articles. In fact, a one day significant swing in stock prices attributed to rumors or relatively inexplicable events may well have more of an effect on shareholder value than the stock options that motivate the performance of executives and other employees and allow them to share in the gains they help create for shareholders.

This debate over the true cost of stock options is sure to continue for the foreseeable future, and there are certainly a variety of ways in which to define and analyze dilution. But with the new accounting rules for EPS calculation, FASB has provided the details necessary to understand the cost of options that have been granted and are outstanding. Options have no value and no cost unless the stock appreciates above the option price while the options are outstanding. The cost of options is reflected in the difference between Basic EPS and Diluted EPS. This difference results in a reduction in share price from what would have been had valuable options not been outstanding. Stock options are a cost to shareholders, not to the company that issues them. Since a company’s aggregate market value is constant at any point in time, any gain in option value results in an equal reduction in total shareholder value available to other shareholders. Our analysis demonstrates that the cost of options measured by the effect on shareholder value is not nearly as burdensome as some reports have contended.

General questions regarding this letter may be addressed to Fred Cook in our New York office (312-332-0910 or email FWCOOK@FWCOOK.COM) or Mike Thompson in our Chicago Office (312-332-0910 or email MATHOMPSON@FWCOOK.COM). Specific technical questions or questions relating to required disclosure in specific company situations should be addressed to appropriate professional counsel.

Copies of this and other materials published by our firm are available on our website, WWW.FREDERICWCOOK.COM

"Stock Options are not a Free Lunch", Forbes, May 18, 1998, pp. 212-217

"Options’ Effect on Earnings Sparks Debate", Wall Street Journal, May 13, 1998, p. C-1

"Will the Real Capitalist Please Stand Up?", Fortune, May 11, 1998, pp. 189-190

"Nice Option If You Can Get It", Business Week, May 4, 1998, pp. 111-112

"Feeding the New Work Ethic", The New York Times, April 19, 1998, Sect. 4

"Council Raises Concerns Over Stock Options Trend", Crain’s Business, April 1, 1998, p. A59

"Some Second Thoughts on Options", "The New York Times, September 21, 1997, p. 1

"The Next Best Thing to Free Money", Fortune, July 7, 1997, pp. 52-62

"Hidden Costs of Stock Options", Directors & Boards, Spring 1998, p. 4

"Raising the Bar", Fortune, June 8, 1998, p.272-278

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