The Advisors' Blog

– Fred Whittlesey, Principal, West Region Practice Leader, Buck Consultants

Poor stock options. How many obituaries have we now read? The post-Enron obituary. The Breeden Report obituary. The FAS123R obituary. And now the bailout/volatility obituary.

Someone once said that where you stand depends on where you sit, and from where I sit I see this a little differently. I’m sitting in California looking out at a lot of technology and life science companies that still remember the proverbial dot-com bust and are now part of the baby being thrown out with the investment banking bath water.

The notion that stock options will become more “expensive” due to recent market volatility might be true…if one measures stock option “cost” solely by FAS123R expense. Not only are lower share prices providing an offsetting factor in valuations, but an integrated financial impact analysis considering cash flow, option gain potential, and dilution can lead to a very different conclusion. In my conversations with clients, it’s become a virtual “no-brainer” that the recent market declines open the door for a mass retreat from prohibitively “expensive” full-value awards and a return, even if temporary, to stock options.

The notion that the expected volatility used for option valuation will increase as described might be true…if one assumes that thoughtful valuation experts will simply take historical volatility data, plug it into Black-Scholes, and accept the result. Much valuation work already excludes “extraordinary” periods of market activity. Companies are actively discussing with their auditors how they will treat the past few months’ data. Do we really expect 5% and 10% daily swings in the future? Probably not.

The notion that there might be limited upside after this “bear market” might be true…if we thought that the declines were completely driven by market fundamentals. The extended flat market of 1968 through 1982 was not due to panic selling but due to the fact that companies were unable to earn a return on capital that exceeded their cost of capital and stock prices reacted accordingly. As we know, much of the selling over the past few months was both forced selling and panic selling, a quite vicious circle. Panic sellers made a run on the market, money managers who didn’t want to sell had to do so to cover, driving the market down further and creating more panic selling.

There’s no question that a rebound in the markets will not be nearly as uniform as the decline. Investors’ eyes have been opened to flawed business models, inadequate cash positions, and the underlying risk of many companies, inside and outside of the financial sector. For companies with solid business models and solid balance sheets, the market downturn is a nice opportunity to deliver cost-efficient gains to employees.

The notion that options are once again deemed to be the underlying cause of risk-taking and moral hazard may be true…and then the dust will settle and we’ll remember that being in business requires taking risk, we don’t really know what excessive risk is in many industries (biotech anyone?), and stock options are a great alignment tool – as long as we don’t provide failure insurance in the form of executive severance, change-in-control agreements, and unreasonably large grants.

Some companies will inappropriately use this period to do market-timed grants – remember the discussions about “bullet-dodging” and “spring-loading” during the option backdating debate? Some companies will convince shareholders that it’s time for an option exchange and double-dip at these low prices. And a lot of companies will make their regular annual stock option grants during their normal annual period and if the market is still depressing their stock price relative to their business fundamentals, then ’tis the season to be jolly.