A Finance Professor's blog.
I am a Professor of Finance in the Poole College of Management at NC State University.
My website: https://sites.google.com/ncsu.edu/warr
Opinions are my own.
I share the same frustration as Buffet and believe I understand where he is coming from. Every public company issues an Annual Proxy Statement that discloses the Employee Stock Option holdings of executive management of the company along with an attempt to value these options. Liquidity is not an issue here really as the options can be cashed in at any time after an initial vesting period. Time and time again I have reviewed these proxy statements and been dismayed at both the number of options granted and the typical massive undervaluation estimated.
I too believe that MANAGEMENT of companies (and not Buffet himself as Damodaran suggests) abuse Black Scholes when using it to value long-term options. I have personally seen options that are in the money by $100 million, valued at much less simply because they have another 5 years of life. Managements use Black Sholes to understate how much they have pilfered from the companies they are entrusted to run.
When valuing an employee stock option, I believe one should just assume the stock price will rise 10% per year for the life of the option (or 8.5% as another post on this blog suggests). I’d love for some academic to use this simple valuation guesstimate and back test it compared to Black Sholes and see which method turns out to be the more accurate once the options are actually cashed in by executive managements in Corporate America.
I'll take it a step further. I think Black Sholes is a tool that managements use to rob the companies they run and it is so rampant that it is causing many if not most US companies to be uninvestable from a Buffet-style buy-and-hold point of view.
And, in a bigger picture, Employee Stock Options are so significant, it presents a tremendous problem in trying to perform a simple DCF valuation of a company - partly because accountants have not figured out a decent way to account for them in the income statement. How do we include these in a DCF model? Most companies have NO IDEA what they are paying their employees until 10 years after-the-fact due to stock options. One of my favorite Buffet quotes: "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?"
I think Damodaran kind of went off the deep end here and became quite defensive because Buffett mentioned academics. Frankly, I think Buffet's true frustration is not Black Sholes, but management’s abuse of Black Sholes and stock option compensation in general. I guess I differ from Buffet on the point of too much focus on option valuation from academics. I think there needs to be MORE research on long-term option employee stock option valuation and how to account for them when trying to value a company.
I'll go another step further and suggest that stock options are ruining our corporations and should be flat out illegal! I'd love to see employee stock options banned and replaced by ACTUAL SHARES OF STOCK. This would more appropriately align management with shareholders. Stock options are one sided and do NOT align management with shareholders. Simply banning stock options would result in companies awarding stock instead of options and management would feel pain when the stock price goes down. Suddenly, managements would be much more conservative in their decision making.
I worshiped Damodaran when I was in his class 15 years ago, and still do. And you rock to Richard! But, I side with Buffet on this one.
Ron I disagree on a couple of points. 1. Valuing an option as if the stock grows at 10% a year would result in an overvaluation of the option. Clearly this is your intention, but arbitrarily picking a high wrong number doesn't seem to be very helpful.
2. Giving CEOs all stock would result in an incentive for CEOs not to take risky projects because they would hold a very undiversified portfolio. From an investor's point of view, I want CEOs to take on risk. I can diversify it away easily. Options allow for risk taking and reduce the downside for the CEO.
While I agree that the accounting for options is a bit of a mess, I don't think that this is an indictment of the pricing model.
I share the same frustration as Buffet and believe I understand where he is coming from. Every public company issues an Annual Proxy Statement that discloses the Employee Stock Option holdings of executive management of the company along with an attempt to value these options. Liquidity is not an issue here really as the options can be cashed in at any time after an initial vesting period. Time and time again I have reviewed these proxy statements and been dismayed at both the number of options granted and the typical massive undervaluation estimated.
ReplyDeleteI too believe that MANAGEMENT of companies (and not Buffet himself as Damodaran suggests) abuse Black Scholes when using it to value long-term options. I have personally seen options that are in the money by $100 million, valued at much less simply because they have another 5 years of life. Managements use Black Sholes to understate how much they have pilfered from the companies they are entrusted to run.
When valuing an employee stock option, I believe one should just assume the stock price will rise 10% per year for the life of the option (or 8.5% as another post on this blog suggests). I’d love for some academic to use this simple valuation guesstimate and back test it compared to Black Sholes and see which method turns out to be the more accurate once the options are actually cashed in by executive managements in Corporate America.
I'll take it a step further. I think Black Sholes is a tool that managements use to rob the companies they run and it is so rampant that it is causing many if not most US companies to be uninvestable from a Buffet-style buy-and-hold point of view.
And, in a bigger picture, Employee Stock Options are so significant, it presents a tremendous problem in trying to perform a simple DCF valuation of a company - partly because accountants have not figured out a decent way to account for them in the income statement. How do we include these in a DCF model? Most companies have NO IDEA what they are paying their employees until 10 years after-the-fact due to stock options. One of my favorite Buffet quotes: "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?"
I think Damodaran kind of went off the deep end here and became quite defensive because Buffett mentioned academics. Frankly, I think Buffet's true frustration is not Black Sholes, but management’s abuse of Black Sholes and stock option compensation in general. I guess I differ from Buffet on the point of too much focus on option valuation from academics. I think there needs to be MORE research on long-term option employee stock option valuation and how to account for them when trying to value a company.
I'll go another step further and suggest that stock options are ruining our corporations and should be flat out illegal! I'd love to see employee stock options banned and replaced by ACTUAL SHARES OF STOCK. This would more appropriately align management with shareholders. Stock options are one sided and do NOT align management with shareholders. Simply banning stock options would result in companies awarding stock instead of options and management would feel pain when the stock price goes down. Suddenly, managements would be much more conservative in their decision making.
I worshiped Damodaran when I was in his class 15 years ago, and still do. And you rock to Richard! But, I side with Buffet on this one.
Ron I disagree on a couple of points.
ReplyDelete1. Valuing an option as if the stock grows at 10% a year would result in an overvaluation of the option. Clearly this is your intention, but arbitrarily picking a high wrong number doesn't seem to be very helpful.
2. Giving CEOs all stock would result in an incentive for CEOs not to take risky projects because they would hold a very undiversified portfolio. From an investor's point of view, I want CEOs to take on risk. I can diversify it away easily. Options allow for risk taking and reduce the downside for the CEO.
While I agree that the accounting for options is a bit of a mess, I don't think that this is an indictment of the pricing model.
Thanks for the comment!