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Subject:  Re: From the Fool on the Hill Archives Date:  10/8/2002  7:53 PM
Author:  Chinwhisker Number:  7983 of 10419

But we don't disagree. Today's follow up Rule Breaker column makes it clear that we use the 5%/3% guidelines precisely because there is a case for the view you cite from Warren. 5% annual ESO grants for newer, developing companies; 3% for established. That 5% is 67% greater than 3%. ;-)

Hi Tom9,

Great to hear from you as well. I agree with your 5% and 3% upper stop limits. At first, I disagreed, but after giving it a bit more thought, as a dilution effect this is a good, quick guideline to set a limit on.

And I also think there's a case that expensing options and the percentage of grants are not linked, but I haven't spent a lot of time on that.

Believe me, I have. The percentages aren't, but finding the real expense for a period from exercised options is easy. Price of option minus price paid minus tax benefit. The problem with granted options (in a current period)is self created. We want to believe we can predict the future effects of the options granted, or outstanding options. I like the Warren Buffet 1/3 rule for granted options. Even though no one year's worth of data isn't going to efficiently account for the rotating effects of options granted in the past, the one year granted options times 1/3 adjusts for acquisitions and mergers quite well. The most recent year will account for the ESO that has been adopted from any companies the parent company has acquired or merged with. The most current years worth of data on granted, and even exercised options, should give a close enough figure to what the total options outstanding are, and looking at this as a percentage to total shares shouldn't be any different.

The 1/3 rule of thumb accounts for the expense in an intrinsic value manner. My best example for determining this would be to bring the stock price of the company 6 to 7 years on average for the exercise price into the future at a 10% to 11% average growth rate. This would put the stock price at double what the current stock price is. That means the employee will have to pay approximately half the share price for exercising the option. The employee then has to pay tax on the spread, and the company receives a tax benefit. For the company this tax benefit on average will be around the standard 35% tax rate. The fact the employee paid for half the share price puts the companies expense at half. The tax benefit which equal close enough to 1/3 reduces this expense to 2/3 the company expense, or 1/3 the actual share price. Discounting the 1/3 expense in the future by a discount rate the same as the growth rate will put the actual expense for the option granted today at the same 1/3.

From this expense you would reduce your beginning adjusted earnings or FCF by. From that, you would further adjust the expense by the growth rate of earnings in your DCF calculations.

OK, here I am trying to tell you something you probably know more about than I ever would. You know how it is, you learn a little something and want to tell everyone. :o)

The point is, determining ESO expense into the future is no more difficult than determining share price into the future. The percentages of outstanding shares dilution doesn't reflect the effects on earnings, but does reflect the effects on shareholder's equity.

I'll shut up, and head toward your follow up now.

Thanks go out to you, Bill and the other TMFs for sharing your thoughts, and keeping the credo "Learning Together" true.

Chin
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