Stock options compensation and opportunity cost II

As Micha pointed out below, although the creation of new stock may be theoretically unlimited, shareholders have the power to put a limit on dilution, and thus practically, scarcity is a real property of stock. After thinking more about the issue over the weekend, here are my current thoughts on the opportunity cost argument for expensing stock compensation.

When I buy a stock, I have certain expectations of the return I hope to receive by ownership of that stock based on current valuation, growth prospects of the company, etc. This is the net present value of future returns of the stock. If the stock price is below this price, I deem the stock 'undervalued' and perhaps buy. If the stock price is above this price, I deem the stock 'overvalued' and perhaps sell it if I already own it.

The mission of management is to maximize shareholder value. When a company gives a stock grant as employee compensation, it conserves cash. When a company sells new stock, it raises cash. This cash can be used in various ways - capital investment, dividends to stockholders, placement in interest bearing accounts, etc.

In order to justify either stock sales or stock grants, this cash must be employed by management in such a way that the return on that cash must exceed the returns I expect on the shares I already own.

For example, if I think that the current company is 'fairly' priced and I expect a future return of 8% a year on the shares that I own, the additional cash must be employed, if management is faithful in its mission to maximize shareholder value, to obtain a return of >8% a year.

Perhaps the additional cash could be used to purchase new capital equipment that might increase market share and boost earnings so that a 'fairly' valued share price grows by 10% a year.

Perhaps the additional cash would be placed in an interest bearing account. This, however, only makes sense if the interest earned is greater than that expected on the shares themselves, in which case it would make more sense for the shareholders to simply sell their stock and put their money in the interest bearing account.

So, the action of raising cash through stock sales/grants has to be justified as a means to increase shareholder value by employing the resulting cash in a manner that yields an overall return on investment greater than the yield expected on 'fairly' priced pre-existing shares. Which is difficult to do, and makes no sense to do via an interest bearing account.

One other factor that comes into play - the resulting dilution itself makes the shares less valuable, so the cash raised must account for this fact in being employed to result in a higher yield than expected of the stock price.

A key point is that both stock sales and stock grants result in an increase in the cash holdings of the company. There is no expense to the company.

What about the opportunity cost argument?

If management is faithful in its mission to maximize shareholder value, it will carry out a stock sale when such an action increases the yield on existing shares. It will issue a stock grant as compensation when such an action increases the yield on existing shares. These actions would be carried out in circumstances in which they are the most effective way to maximize shareholder value. If opportunity cost is defined as the end foregone, that end will be the most highly valued end not taken, but if it is the second best option, it makes no sense to report it as an expense.
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Follow-up posts:
Stock options compensation and opportunity cost
Employee compensation: cash vs. stock
Candy bars and movie tickets
Kling on stock-based compensation

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I agree that stock

I agree that stock compensation should not be included with other expenses, but do you believe that it should be listed on the financial statements as a seperate item or not at all?

Granted stock should be

Granted stock should be listed on financial statements where it belongs - added to the total number of outstanding shares.

And now that I think about it, granted options that have not yet been exercised should be treated the same way.

Jonathan, Scarcity is not a

Jonathan,

Scarcity is not a real property of stock, to the company that can create it out of thin air.

Analogy --

You are tending the cash register in a carnival for a man whose business it is to sell dinner plates. He was formerly a magician, but found that it didn't pay enough.

To your left is a popup stack of plates. Whenever a customer wanders by, every 3 minutes or so, you take the top plate off the stack and sell it to the customer. You have never seen the stack of plates run out. If you drop a plate and break it, will or should the owner deduct the price of a plate from your pay? Why or why not?

Regards, Don

Don, I agree there is no

Don,

I agree there is no theoretical limit to new stock, but it is only beneficial in finite amounts. Ideally, every time it is issued, management is being true to its mission of maximizing shareholder value.

The owner should not deduct the price of the plate from my pay. The plates are limitless to him, and any end he wishes to obtain through them is still available for pursuit. He has not suffered an expense.

Jonathan, Follow-up

Jonathan,

Follow-up question.

Devise a method for EXACTLY reimbursing the owner for his economic losses no matter whether or not the number of plates is infinite or how many plates you break.

Regards, Don

Don, Devise a method for

Don,

Devise a method for EXACTLY reimbursing the owner for his economic losses no matter whether or not the number of plates is infinite or how many plates you break.

Starting out, I separate it into two parts:

1) If the number of plates is infinite, the reimbursement of broken plates, no matter how many there are, is exactly zero.

2) If the number of plates is finite, I reimburse him for the sum total amount that he could have sold the plates for.

To combine these two parts into a general principle:

Whether or not the number of plates is finite or infinite, and no matter how many plates I break...

...I reimburse the magician for the sum total of all sales he fails to carry out due to my clumsiness.

Jonathan, To elaborate

Jonathan,

To elaborate slightly, continue to work as always, maintaining a count of broken plates. As soon as a customer wanders by AND cannot be sold a plate because the stack is empty, express your sorrow and pay for one of your broken plates yourself, paying the current price. Repeat this process until a customer has appeared for each of your broken plates. You can now close up shop for good, having reimbursed the owner the proper price for each broken plate at the proper time.

Regards, Don