Economic Puzzle Involving Stock Ownership, Part II

Subtitle -- The Absurdity of Stock and Option Expensing

In Part I , I attempted to set up and explore an ultra simple example dealing with the economic and logical reality involved in the relationship between a company and its shareholder owners.

One would have thought that the fact that a company and its shareholders are separate entities involved in a specific relationship would have been a universally accepted truism. However, the arguments made both for and against option expensing (and by extension, stock expensing) testify otherwise.

Shareholders own a company in direct proportion to the number of shares that they own. The only shares that count in this calculation are the ones actually owned by independent, external individuals or firms. In particular, shares that the company itself may possess are of no significance to anyone. ( see answers in Part I)

Every expense suffered by a company is also an expense suffered by its shareholders, in proportion to their ownership percentage.

The reverse is NOT true, as variations in the distribution of share ownership between individuals and firms that may enhance or diminish their positions have NO effect on the company itself.

Going back to Part I, in question #2d, one share of stock is transferred from the company itself to a non-stock holding individual. This is the basic form of a stock grant intended as employee compensation. If this is to be recorded as an expense to the company, it would have to diminish the value of the company itself. It does no such thing, but instead dilutes the value of the shares held by the existing external shareholders. In total, the value gained by the employee is exactly matched by the dilution of the existing shareholders. There is NO additional expense remaining to be allocated.

To further this point, any stock grant to an employee can be accomplished with exactly the same result by first splitting the stock and then having the existing shareholders transfer their new split shares to the employee. Certainly, neither step in this alternate process can be considered as any kind of an expense to the company.

Taking the opposite tack, consider an alternate path for compensating an employee with cash. This is clearly an expense to the company, and a benefit to the employee, $5 in each case, covered by question #2b in Part I.

Instead of directly compensating the employee with $5, first grant him a share of stock, and then buy it back for $5. We know that there is a $5 expense to the company, but does the expense come from the stock grant or from the buyback?

We can answer this question by looking at the effect on the existing shareholder. After the grant, but before the buyback, the existing shareholder has lost half of the value of the company. For this loss to be equal to the $5 gain of the employee, the company itself must still have a $10 value. Thus it must be the buyback that is the real expense to the company. This is not remarkable in that the $5 paid for the stock is an actual expense and the stock returned to the company no more represents a gain to the company than it represented a loss when it originally left. From the POV of the shareholder, the buyback is a wash as his increased ownership percentage of the company is exactly offset by the $5 in cash paid by the company.

The fact that the buyback is a wash to the shareholder is undoubtedly one reason why it has never been treated as an expense.

However, there are traditionally three reasons that a company has advanced to justify the expenditure of shareholder cash to buyback shares.

1. The stock is undervalued and a good investment. This is legitimate, but has a caveat. The fiduciary responsibility of management to shareholders implicitly requires that every dollar so expended must, in the judgment of management, have no alternative investment opportunity that will yield a superior risk-adjusted return.

2. Buying back stock has a tax advantage to shareholders over paying out cash dividends. This is also true, but only to a degree. It is most true for shareholders in the highest marginal tax brackets and not true at all for shareholders with their shares in tax deferred accounts. Not surprisingly, buying back stock is most advantageous for the highest paid company esecutives who hold stock.

3. Companies actually come out and say in SEC filings that they are buying back stock to offset the dilution of stock and option grants to employees. This is absurd. Buying back stock doesn't undo the damage to existing shareholders of dilution, but rather only serves to hide the extent to which the company management has been looting the free cash flow of the company.

In summary, all of the arguments on how to value options to expense them are utterly useless. The true cost to the company itself of both stock and option grants is precisely ZERO. The proper target for expensing to control company looting by management is on the other end, i.e. stock buybacks.

Original Puzzle

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