Saturday, November 22, 2014

How Stock Options Inflate Payout Ratios

Imagine a firm with a price to book ratio of 1, worth \$100 million, with \$100 million in revenues, 10% profit margin (\$10 million per year) and a 50% payout ratio.  Each year, owners receive \$5 in dividends, and the firm reinvests \$5 million, so that the following year, the firm is worth \$105 million, etc.

Now, imagine that the firm replaces \$1 million of cash wages with \$1 million worth of stock options.  Let's say that, on average, when those options are exercised, employees receive \$5 million worth of stock, but only pay \$4 million for it.  And, let's assume the firm has a policy of purchasing the shares on the open market when those options are exercised.  So, in a typical year, the firm will repurchase \$5 million dollars worth of shares in order to distribute stock to employees through the stock option program.

Note, the firm still has \$100 million in revenues, \$10 million in profit (\$11 million in profit from operating cash flows minus \$1 million in GAAP expense from the stock options), and \$5 million in dividends.  And they still reinvest \$5 million into the business (\$11 million in profit from operating cash flows, minus \$5 million dividends, minus \$5 million in buybacks, plus \$4 million from employee option exercises).

But, now, they have a 100% payout ratio instead of a 50% payout ratio - just by replacing 1% of market cap. with stock options in lieu of cash wages.  But true profit and profit retention remain unchanged.

PS.  I use the antidilution stock buyback here for consistency in the example, but the options cause the gross payout ratio to be inflated regardless of the buyback policy.  When the option is exercised, the firm receives cash equal to the strike price of the optioned shares.  This is a capital inflow from the employee.  The exercise of the options mean that, ipso facto, the firm had higher capital inflows than would be inferred from gross capital distributions.
 Firm with all cash wages Firm with Stock Options Cash Profit \$10 \$11 Options Expense \$0 \$1 Net Profit \$10 \$10 Less: Dividends \$5 \$5 Less Buybacks \$0 \$5 Operating Retained Cash \$5 \$0 Add Stock Sales \$0 \$4 Add back Option Accrual \$0 \$1 Total Retained Cash \$5 \$5 Total Gross Distributions 50% 100% Total Net Distributions 50% 50%

1. This is very helpful.

So, in this transaction the volume of shares outstanding is unchanged. Does it follow that the change in float, times the prevailing price, would be a reasonable measure of repurchases that are genuine payouts to shareholders?

2. Or, what if we just net out stock sales from stock purchases? In your example, I assume the \$4 million shows up in the cashflow statement, right? And, I guess, use cashflow from operations rather than income. That is easily doable, and seems like it would fix the problems you're pointing to.

In general, I would prefer to do everything on a cashflow basis. The only problem is that doesn't work for long-run historical stuff, since Compustat has only income statements prior to 1971.

1. That seems right to me, conceptually. I don't know how IPOs, etc. would effect the aggregate number, though. But, it seems like net financial cash flows from buying or selling stock would be a place to look for a clean number, in terms of cash.

3. Interesting post.

4. Your accounting for the stock option expense is not correct as far as "profit" is concerned. As from 2005, GAAP requires that fair value be used for the expense at the date of grant. Black and Scholes is normally used to calculate fair value if there is no public market for the type and duration of the option concerned. See FAS 123. This expense is not reversed if an option remains un-exercised.

But, the general point about returns to shareholders is correct--companies often purchase their shares on the open market to fund employee stock option schemes (or to offset newly issued shares used for the same purpose) and this significantly inflates the perceived return to shareholders (in contrast to employees) through buybacks.

1. I am assuming that the expense for the options reflects their average cost over time across firms. This does get complicated, though, since much of the cash return to the employee reflects returns to equity over time.

Buybacks don't inflate perceived returns. I disagree with that observation.

2. Your specific example compares one hypothetical firm (with options) to another hypothetical firm (without options)---not across firms. Further, are you aware of any studies confirming that "the expense for the options reflects their average cost (here, I assume you mean cash outlays) over time across firms"? If not, why would one make that assumption? :

"Note, the firm still has \$100 million in revenues, \$10 million in profit (\$11 million in profit from operating cash flows minus \$1 million in GAAP expense from the stock options), and \$5 million in dividends."

You appear to not acknowledge any distinction between perceived returns to shareholders and actual returns. Quite a number of people seem to think that share buybacks increase such actual returns. Indeed, this seems to be suggested by your own title to this post: "How Stock Options Inflate Payout Ratios".

3. I am imagining a hypothetical firm representing the average over time. It's admittedly simplified, but not in any way that distorts the main point. The precise relationship between expenses and cash outlays becomes very complex. But the expense issue is tertiary.

My post is about payout ratios, which is a separate topic from returns or growth rates. Mostly this is a response to time series that compare aggregate gross payouts over time. My hypothetical suggests that gross payouts would be overstated because of options so that net payouts are a more appropriate comparison. But this would be largely irrelevant to the issue of perceived returns, since changes in per share earnings would generally reflect net changes in share counts. I don't think buybacks create any significant long term distortions in valuations, but that isn't the topic of this post.

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