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Author: RoughlyRight Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 212015  
Subject: Option Grants Date: 5/30/2001 1:04 AM
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At BRK's 2000 annual meeting, I asked a question regarding valuing stock options. Warren's short-hand answer was that for a company paying no dividends and issuing 10-year at-the-current-stock-price options, one should subtract from net income 1/3 of the value of multiplying the # of options granted times the exercise price.

I was glad to hear that this was roughly the same answer that I was getting with my own calculations. I like to think of employee stock options as basically giving employees an interest-free loan to buy the company's stock. But even better than an interest-free loan, if the stock goes down, the employee can subtract from the principal due, the decline in the stock (therefore the employee can never lose money!). For this never-lose-money feature, there is usually a vesting period. I figure these features roughly balance out.

Let's go through an example. If a company lends you $5,000 for 10 years to buy 100 shares of stock at $50, what is the value of the loan if interest rates are 7%? Well, at 7% interest, $5,000 would grow to $10,000 in 10 years. At which time you pay back the original $5,000, and you are left with $5,000 in profit. But, this $5,000 profit received in year 10 has a present value of $2,500. Therefore, the company is giving you $2,500 in today's dollars. If the company had paid this in cash, it would have reduced reported gross income by $2,500, or net income by $1,625 (35% tax rate assumed). What do you know, $1,625 is Warren's short-hand answer (1/3 of $5,000)!

An associate of mine went through and tabulated the option costs over the last 4 years for about 145 well-known companies. It is very interesting to see the trends in place at certain companies and how reported income is affected. Below is a link to a work-in-progress spreadsheet that we've developed. Enjoy.

http://www.checkcapital.com/clients/clientsframe.htm

RoughlyRight
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