Warren Buffett (Trades, Portfolio) has long been an opponent of stock-based compensation for company executives. He has argued multiple times that the practice creates broken incentives for managers and that it is typically not good for shareholders. In his annual Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) letter from 1992, he explained how executives like to justify the use of stock options, and why these arguments ultimately do not hold much water.
A real expense
Buffett took issue with the idea that stock options should not be recorded as a real expense in annual accounting statements. According to him, one of the main arguments put forward by executives is that since they are not paid for in cash, they are not really an expense. He then pointed out the fallacy in this argument. If stock options really aren’t a cost, then executives should feel comfortable using them to pay for a wide range of items, including insurance:
“If you're a CEO and subscribe to this 'no cash-no cost' theory of accounting, I'll make you an offer you can't refuse: Give us a call at Berkshire and we will happily sell you insurance in exchange for a bundle of long-term options on your company's stock."
The second argument that Buffett addressed is that stock options are just too difficult to value, and therefore shouldn’t be accounted for in reporting. He had two responses to this claim. The first is that plenty of things in business are difficult to value, yet we still insist on at least trying to estimate them. No other hard-to-calculate cost is excluded from reporting, so why should options be?
“Shareholders should understand that companies incur costs when they deliver something of value to another party and not just when cash changes hands. Moreover, it is both silly and cynical to say that an important item of cost should not be recognized simply because it can't be quantified with pinpoint precision. Right now, accounting abounds with imprecision. After all, no manager or auditor knows how long a 747 is going to last, which means he also does not know what the yearly depreciation charge for the plane should be. No one knows with any certainty what a bank's annual loan loss charge ought to be. And the estimates of losses that property-casualty companies make are notoriously inaccurate.”
His second response was that options are not actually that difficult to value. Sure, the exact number may be somewhat hazy. But it is clear that they do have some value, a point Buffett illustrated with the following offer:
“In fact, since I'm in the mood for offers, I'll make one to any executive who is granted a restricted option, even though it may be out of the money: On the day of issue, Berkshire will pay him or her a substantial sum for the right to any future gain he or she realizes on the option. So if you find a CEO who says his newly-issued options have little or no value, tell him to try us out. In truth, we have far more confidence in our ability to determine an appropriate price to pay for an option than we have in our ability to determine the proper depreciation rate for our corporate jet.”
Stock options represent a free, open-ended payoff opportunity, and therefore they have real value. Moreover, this value is gained at the expense of shareholders, whose equity is diluted by the issuance of options.
Disclosure: The author owns no stocks mentioned.
Read more here:Ă‚
Seth Klarman: Value Investing in a Turbulent EnvironmentÂ
Howard Marks: Doing the Right Thing at the Right TimeÂ
Warren Buffett on Negative Interest RatesÂ
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