Options Expensing: Another Headache
If you think Tuesday's post-close news was bad, consider P/E ratios while accounting for the expensing of options.
Nick Godt
Companies whose fiscal year begins in January (aka most firms) will have to disclose the options they'd granted to executives and employees as an expense in their first-quarter earnings reports. Yet, analysts won't have to include them in their earnings forecasts.
That's already creating a headache for investors trying to figure out the value of their stocks based on forward earnings. Bank of America strategist Thomas McManus, for one, says his office has fielded numerous questions from investors trying to make heads or tails of what the new accounting rules might mean for stocks and their valuations.
As the fourth-quarter earnings season starts, there's more room for confusion.
(IBM) - Get Report
, which posted
mixed earnings after the close Tuesday, previously said the
is now formally probing the way it expensed options in the first quarter of 2005.
Big Blue is notorious for the "aggressive" way it accounts for its pension costs to smooth out earnings, according to Morningstar analyst Rod Bare. But it had voluntarily chosen to expense options before being required to under the new accounting regulations.
So much for trying to do the right thing. IBM shares fell 0.2% Tuesday and dropped another 1% after hours even after the company posted disappointing top-line results.
(INTC) - Get Report
, which hasn't started expensing options yet, posted
disappointing revenue for the fourth quarter and lowered its guidance for the coming quarter, sending its shares down 8.5% in after-hours trading.
(YHOO)
, which
also missed earnings expectations, dropped a whopping 12% after hours.
That combination will almost certainly pressure stocks early Wednesday. On Tuesday, surging oil prices and broker downgrades of
(AMD) - Get Report
(SNDK)
kept the broad stock averages in the red.
dropped 63.55 points, or 0.58%, to 10,896.32; the
lost 4.68 points, or 0.36%, to 1282.93; and the
fell 14.35 points, or 0.62%, to 2302.69.
Apples and Oranges
The traditional metric used to determine the value of a company's stock is the price-to-earnings (P/E) ratio. For the forward-looking stock market, that means looking at earnings expected over the next 12 months.
If expected earnings were to suddenly include the cost of options, 2006 earnings for S&P 500 companies would be cut by 3%, according to Credit Suisse First Boston. Lower earnings would mean higher P/E ratios, indicating that stocks have become more expensive relative to other assets such as Treasuries.
The most affected sector of the market would be technology, where firms had been relying on options to make up for a lack of cash when rewarding employees since the 1990s. According to Goldman Sachs analyst Rick Sherlund, earnings at software companies, for instance, would drop by 17% in 2006 should options expenses be counted against earnings.
What's sustaining earnings forecasts currently is that most Wall Street analysts have so far resisted including options expensing into their estimates. Forecasting firms, such as Thomson First Call, likewise, continue to tally earnings forecasts that don't include options expenses.
Thomson analyst John Butters says the firm will display two tables in the cases in which some firms have started expensing, and when some analysts do take them out of their earnings forecasts. But the so-called consensus earnings forecast uses the method that a majority of analysts prefer, and that remains without options expensing.
It may sound confusing, but until companies and analysts can do apples-to-apples earnings comparisons from one year to the next, analysts' reticence to include options expensing should continue to protect stock valuations.
"Right now, it's an apple-to-orange comparison," says Barry Hyman, market strategist at Ehrenkrantz King Nussbaum. "It will have to be another year until we can really compare" earnings that include stock options costs for both years.
According to McManus, the fact that companies, even in the tech arena, have began to scale back their options grants, or have accelerated their vesting period, should lessen the shock investors might have felt when firms start expensing.
Options expensing was an issue in 2000 when unexpensed options accounted to 0.9% of S&P 500 revenues, McManus says. But corporate revenue has risen at an annualized 5% rate since then. And combined with smaller option grants, unexpensed options account for only 0.3% of S&P 500 sales.
Similarly, Sherlund believes that overall stock prices don't have to be impacted much, if at all, given that the issue has been extensively discussed over the past three years.
Still, he believes it's the potential for confusion about how analysts treat the expense that may create some risks for stocks, especially where changes in earnings caused by expensing are the greatest.
Software companies such as
(ORCL) - Get Report
should see only a 3% drop in their 2006 earnings once they include options costs.
But flashing warning signals on Sherlund's radar screen are the likes of
(RHAT)
Siebel Systems
(SEBL)
(CRM) - Get Report
, whose earnings would drop 47%, 56% and 89%, respectively, when options expensing is included.
In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;
to send him an email.
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