The High Cost of Dell's Stock Option Program, Part 3

The True Cost of Options

So what are stock options really worth?

A precise answer is impossible, but at last year's Berkshire Hathaway annual meeting, Warren Buffett said that for non-dividend-paying stocks, his standard rule of thumb is that an employee option is worth one-third of its exercise price (typically, this is the market price of the stock when the option is granted). Fortune also uses this "unscientific but common practice" in its must-read article on stock option accounting.

Let's use this estimate to figure out roughly how much the 154 million options Dell granted last year were worth. We don't know exactly when the options were granted during Dell's last fiscal year (Jan. 31, 2000, to Feb. 2, 2001), so we don't know their average price. But the stock's range was $16.63 to $58.13, the average price for the shares Dell repurchased was $41.54 and the average stock price during the fiscal year, according to Bloomberg, was $38.23. It's tempting to use the latter figure, but it's probably too high because many of the options were likely granted after the stock had fallen quite a bit, so let's use a number at the low end of this range -- say, $25. So, 154 million options times $25 times 1/3 is equal to $1.28 billion, which is more than double the $620 million pretax figure that Dell reported in its 10-K.

The difference is mostly because Dell spreads the cost over the vesting period, which is perfectly legitimate. In my opinion, however, the options granted last year should be expensed against last year's earnings, adjusting for anticipated forfeitures (which the one-third-of-the-exercise-price estimate already factors in). Thus, $1.28 billion minus tax is $898 million, which would reduce Dell's reported net income by 41% (rather than the 20% reduction Dell reported), making its current P/E ratio a rich 58.7.

A 41% earnings haircut doesn't surprise Scion Capital's Michael Burry, who says: "As a rule of thumb, when I look at tech stocks that rely on options compensation to a great degree, I start with a 30% downward adjustment to earnings per share. In many cases it turns out to be much more than that."

Conclusion

Many smart people have been beating their heads against a wall on this issue for years, and I still haven't seen the perfect solution. But a reasonably accurate estimate using the technique I've outlined should work just fine. As Buffett said: "It's better to be approximately right than precisely wrong."

The takeaway here is not that one should always avoid the stocks of companies that issue lots of options. Rather, the key for investors is to be aware of the impact of large stock option grants when evaluating a stock, and make appropriate adjustments.

Return to Part 1 of this column, or to Part 2.