210 InManagersWeTrust
stoc kprice rises above the exercise price, the optionees will exercise
the option and share in the increase with shareholders. But if eco-
nomic performance is unfavorable and the stoc kprice remains below
the exercise price, optionees simply will not exercise the option.
Shareholders suffer from the corporation’s unfavorable performance,
but an option holder does not.
These awards also exacerbate the misalignment of interests be-
tween corporate option holders (usually senior executives) and other
workers. The awards dramatically increase the compensation differ-
ential between highly paid executives and ordinary laborers, a ratio
which is significantly higher in the United States than it is in Europe
and elsewhere. Accordingly, when stoc koptions are used, they
should be spread throughout the employee base—as GE has done—
rather than limited to the top dogs.
Stock Option Costs
The direct cost to shareholders of stoc koption compensation is the
dilution of their ownership interest. A common managerial response
to the dilution is to buy bac koutstanding shares. The trouble with
that solution is that it devours corporate funds that might be more
profitably deployed.
Shocking indirect costs are accounting rules that fail to require
employee stoc koptions to be recorded as an expense on the income
statement.^8 This translates into earnings per share figures that over-
state actual earnings for companies with executive stoc koptions out-
standing. Even the diluted earnings per share figure does not reflect
these costs.
Accordingly, you must adjust earnings figures for the cost of op-
tions. Doing this is not easy, however, for not all information is nec-
essarily found in the financial statements. You need to examine the
footnotes for something called overhang, which is the percentage of
the company that outstanding stoc koptions would represent if they
were exercised. The average percentage has mushroomed from under
10% a few years ago to nearly 15% now.
Still, the actual cost of options is not presented directly, though
there is some footnote disclosure about this. The real cost equals
the price at the time of exercise minus the amount the executive
pays (the exercise price). This is the truest measure of cost because
the company could have generated that much by selling the optioned
shares to others at the prevalent price instead of at the option price.
The cost of executive stoc koptions is substantial, averaging