The direct cost to shareholders of stockoption compensation is the dilution of their ownership interest. A common managerial response to the dilution is to buy back outstanding shares. The trouble with that solution is that it devours corporate funds that might be more profitably deployed. Shocking indirect costs are accounting rules that fail to require employee stockoptions to be recorded as an expense on the income statement. This translates into earnings per share figures that overstate actual earnings for companies with executive stockoptions outstanding. Even the diluted earnings per share figure does not reflect these costs.

Accordingly, you must adjust earnings figures for the cost of options. Doing this is not easy, however, for not all information is necessarily found in the financial statements. You need to examine the footnotes for something called overhang, which is the percentage of the company that outstanding stockoptions would represent if they were exercised. The average percentage has mushroomed from under 10% a few years ago to nearly 15% now.

Still, the actual cost of options is not presented directly, though there is some footnote disclosure about this. The real cost equals the price at the time of exercise minus the amount the executive pays (the exercise price). This is the truest measure of cost because the company could have generated that much by selling the optioned shares to others at the prevalent price instead of at the option price. The cost of executive stockoptions is substantial, averagingabout 5% of annual earnings among S&P 500 companies and in some cases amounting to half of reported earnings, including at Yahoo!, Polaroid, and Palm.9 In less dramatic but still striking examples, if stockoptions were recorded as a cost, the 1999 earnings of some major companies would be slashed: Cisco, 24%; Microsoft, 12%; IBM, 8%; and Oracle, 16%.10 These cost effects extend for many years, depending on the life of the options. At many companies, options have a life of five years. Increasingly, companies extend their lives to as long as 10 and 15 years.


Legal rules are ill equipped to police executive compensation. The general stance of U.S. courts is to evaluate compensation issues, if at all, under a waste standard. This standard rarely upsets corporate decisions. Waste requires pretty much the irrational trashing of corporate assets in ways akin to dumping truckloads of cash into the Hudson River. In the case of executive compensation, U.S. courts are quite deferential to management indeed.

As for securities disclosure laws, the SEC requires substantial and focused disclosure of top executive compensation in comparative performance charts. Nevertheless, corporations continue to structure executive compensation packages so that they don’t show up in the bottom-line numbers. For example, after accounting standard setters ruled that a reduction in the exercise price of a previously issued option had to be recorded as an expense on the income statement, many companies chose instead to extend the life of the option.

Without effective legal or accounting regulations, the chief job of policing executive compensation lies with the corporate board. Board members must insist that executive compensation peg individual contributions to corporate performance. Measuring executive performance by business profitability is the most definitive yardstick with regard to shareholder as well as labor interests. When measuring performance, companies should reduce earnings by the capital employed in the relevant business or by the earnings the firm retains.

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