QUALIPORT
The True Cost Of Share Options

By Maynard Paton (TMFMayn)
August 17, 2004

"It seems to me that the realities of stock options can be summarised quite simply: If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?" -- Warren Bufffett, 1993

The adoption of international accounting standards in 2005 will force UK firms to reveal the true cost of their share options. And the new rules could give many investors a shock. One consultancy believes profits at the top 25 FTSE 100 firms could be reduced by 5.4% under the new practice.

Details and limitations of the current accounting practice for options are somewhat protracted, but Sir David Tweedie, chairman of the International Accounting Standards Board, summed up the situation well when International Financial Reporting Standard 2 Share-Based Payment (IFRS2) was issued:

"Typically, transactions in which share options are granted to employees are not recognised in an entity's financial statements. As a result, the entity's expenses are understated and its profits are overstated, which is potentially misleading to users of financial statements. The objective of IFRS 2 is to require that, no matter what form of remuneration is used, the entity recognises the associated expenses." 

In a nutshell, IFRS2 (pdf) applies to grants of shares, share options or other equity instruments made after 7 November 2002. Calculating the 'fair value' of these awards though is a complex affair, with the Black-Scholes approach or the Binomial method seen widely as possible solutions.

Suffice to say, with today's accounts supplying limited option information and the need to use complex Wise formualae, the ordinary investor is going to have a very hard time accurately estimating the true cost of options pre-IFRS2. Read more on options.

Nevertheless, investors can do some investigative groundwork now to highlight companies with potentially large IFRS2 charges.

Dilution

A popular way of unearthing unfavourable option schemes is to compare the number of shares used to calculate basic earnings per share (EPS) with the equivalent for diluted EPS. Essentially, the diluted EPS calculation assumes any outstanding 'in the money' options (i.e. those with an exercise price lower than the market price) at the year-end were exercised during the year. Read more on diluted EPS.

Here's how the Qualiport watch list measures up in the dilution stakes:

Company	Year end	Weighted average basic share count (000s)	Weighted average diluted share count (000s)	Dilution (%)
Associated British Ports (LSE: ABP)	Dec 2003	329,000	331,000	0.61
Capital Radio (LSE: CAP)	Sep 2003	82,071	82,161	0.11
Emap (LSE: EMA)	Mar 2004	256,000	258,000	0.78
Gallaher (LSE: GLH)	Dec 2003	650,000	651,700	0.26
Games Workshop (LSE: GAW)	May 2004	30,223	30,718	1.64
GlaxoSmithKline (LSE: GSK)	Dec 2003	5,806,000	5,824,000	0.31
Halma (LSE: HLMA)	Mar 2004	366,238	366,687	0.12
Imperial Tobacco (LSE: IMT)	Sep 2003	724,328	727,553	0.45
Johnston Press (LSE: JPR)	Dec 2003	283,576	285,629	0.72
London Stock Exchange (LSE: LSE)	Mar 2004	293,000	295,700	0.92
Renishaw (LSE: RSW)	Jun 2004	72,789	72,789	0.00
Rotork (LSE: ROR)	Dec 2003	85,800	86,200	0.47
Ulster Television (LSE: UTV)	Dec 2003	52,959	54,678	3.25
Vodafone (LSE: VOD)	Mar 2004	68,096,000	68,096,000	0.00

On this basis, there doesn't seem to be too much to worry about, with most companies having a potential share dilution of below 1%. Without an option scheme in operation, Renishaw will be the only watch list firm unaffected by IFRS2.

Though Vodafone also recorded zero dilution, it does run an option scheme. The telecom group considered in 2004 that there were no 'dilutive potential ordinary shares' for EPS purposes, due to its dilutive share count being lower than the basic share equivalent. But if it grants further options, Vodafone will still be liable to an IFRS2 charge.

Although nothing to do with liberal share option schemes, the presence of various 'convertibles' and warrants can also lead to earnings dilution.  For instance, Ulster Television issued a convertible loan note in 2001, whereby the note's holders can opt to redeem the debt into Ulster shares at a specific time. The bulk of Ulster's potential 3.25% dilution involves this particular instrument.

All your options

As the dilution at Ulster and Vodafone suggest, diluted EPS is not an ideal indicator for highlighting liberal option distributors. One particular problem is that significant share price moves can affect its calculation. For instance, if a company experiences a sudden share price decline, then the potential for dilution reduces as 'in the money' options become 'out of the money'.

Investors should therefore compare a company's share capital against ALL outstanding options. Sadly, companies are not obliged to present a simple options total in their annual report and investors may have to tot up the figures from several (and sometimes complex) schemes. Here's how the watch list scores on this particular measure:

Company	Year end	Year end  basic share count (000s)	Year end option count (000s)	Options/ basic shares (%)
Associated British Ports	Dec 2003	329,235	9,951	3.0
Capital Radio	Sep 2003	82,991	3,797	4.6
Emap	Mar 2004	256,600	6,382	2.5
Gallaher	Dec 2003	653,600	5,900	0.9
Games Workshop	May 2004	30,847	808	2.6
GlaxoSmithKline	Dec 2003	5,949,464	429,346	7.2
Halma	Mar 2004	366,774	16,580	4.5
Imperial Tobacco	Sep 2003	729,,200	6,594	0.9
Johnston Press	Dec 2003	283,985	5,465	1.9
London Stock Exchange	Mar 2004	297,000	9,967	3.4
Renishaw	Jun 2004	72,789	72,789	0.0
Rotork	Dec 2003	85,840	524	0.6
Ulster Television	Dec 2003	53,486	1,182	0.6
Vodafone	Mar 2004	68,263,933	1,093,200	1.6

GlaxoSmithKline is top of the list for generous options plans and warrants further investigation. Indeed, the company emphasises the problems with the diluted EPS calculation, with some 429m outstanding options dwarfing the extra 18m used in its dilution figure.

Fortunately, Glaxo also provides the best accounting pointer to IFRS2. Being a FTSE multinational with ADRs listed in the United States, Glaxo's annual reports reconcile earnings reported under UK account practices to those reported under US standards.

The reconciliation includes 'stock-based compensation', which is calculated under similar rules to IFRS2. The after-tax effect of the compensation over the past five years is shown below:

Year to       December 31	Underlying earnings (£m)	Stock-based compensation (£m)	Compensation/ earnings (%)
1999	3,222	(203)	(6.3)
2000	3,697	(263)	(7.1)
2001	4,383	(162)	(3.7)
2002	4,627	(331)	(7.2)
2003	4,765	(379)	(8.0)
Total	20,694	(1,338)	(6.5)

If the option grants continue (the number outstanding rose 94% in the three years to December 2003), Glaxo's earnings could be reduced by 6-7% following IFRS2 -- certainly something to consider when it comes to valuation!

Among the others on the list, the relatively high option count at Capital Radio and Halma may in time provide some buy price adjustments. Capital seems the more worrying of the two. During the five years to September 2003, the number of outstanding Capital options has surged 91%. At Halma, the five years to March 2004 has witnessed options increase 17% in number.

But it remains to be seen what actual effect IFRS2 will have on the watch list, and indeed whether the new standard will curtail option grants generally.

More: Accounting For Options | Fool's Guide To Earnings Per Share

Maynard owns shares in Associated British Ports, Games Workshop, GlaxoSmithKline, Halma, Johnston Press and London Stock Exchange.

Qualiport value

Holding	Number of shares	Closing price 16/08/04 (p)	Value (£)
Associated British Ports	681	405.5	2,761.46
Emap	372	710	2,641.20
Halma	1,920	142.25	2,731.20
Johnston Press	1,608	511	8,216.88
London Stock Exchange	1,669	343.75	5,737.19
Cash			1,198.94
Total			23,286.87