Stock Options as Compensation
Aug 22nd, 2007 by Martin Lee
Berkshire Annual Letter 1998 (Part 3)
Many companies ignore the cost of stock options when earnings are calculated, even though such employee’s compensation should be an expense.
Imagine that GEICO spends $190 million for advertising and pays for it all using Berkshire options. Isn’t that an expense, and should be charged accordingly to the earnings?
When Warren Buffett looks at investing in an option-issuing company, he will make a downward adjustment to reported earnings based on the market value of the options. It often cuts down the reported earnings by 5% or even 10%.
He also includes in his evaluation the cost of replacing any option plan.
Sometimes, stock options are not exercised. Companies also recieve a tax deduction when employee options are exercised. However, these two mitigating factors are offset by a something common: Options issued to employees are often repriced.
If options are not a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?
