Gretchen Morgenson proves she can divide and subtract

This week Gretchen Morgenson is writing about executive compensation. Who'd a thunk it.

Her specific issue is how share repurchases can help executives whose pay is pegged to earnings per share. So she's proved that she can divide -- when the denominator goes down and the numerator stays the same the fraction is larger.  Very good, Ms M.

But here comes the tricky part.  What if the numerator goes down too???  The question is, what was the cash doing before it bought the shares. Morgenson assumes that "companies can hurt their financial positions by putting scarce cash into repurchases." So she figures that the cash was being used more productively before it bought the stock. That's why it was "scarce." This suggests that earnings might go down because of the repurchase. And then eps might go down, or stay the same.

But I'll pass all that and get to the dumbest part of the column. She says

when buybacks are used to offset multitudinous stock option grants to corporate executives, an even more pernicious outcome can occur: the purchases may actually destroy shareholder value by forcing companies to essentially buy stock in the open market at high prices to cover shares sold at lower prices to executives.

Ok, now Ms M proves she can subtract, too. But wait.  How does one number relate to the other?  It's fine to prove you can subtract, but you really should know why you're subtracting. Why should we care about the difference between the share price at the time of the repurchase and the share price at the time of the option exercise?

Believe it or not this isn't the first time Morgenson has uttered this stupidity. Last July the inimitable Ms M said:

you can also weigh option costs another way — by analyzing how much money companies must spend to buy back shares that the granting of options creates. Amounts spent on these buybacks . . . reduce a company’s net worth. . . .

I commented:

What Morgenson wants us to believe is that if executives pay $9/share for optioned stock and the company later pays $18.00 for its shares, the cost of the options to the company is not the the cost of the options to the company as we have always thought but the $9/ share difference between the insiders' price and the eventual buyback price.

You know, if you're a lead financial columnist for one of the most prominent newspapers in the world, you really have to be able to do more than subtract and divide.

Comments

[Kevin]

I love it. Now options and, by unavoidable extension, the the people who receive them are bad because the company might choose to ride a short position in its own shares.

Gretchen should capitalize on the New Year by publishing a top-10 (100? 1000?) list of reasons not to work for a public company. Since that isn't going to happen (agendas should only be laid so bare, you know), maybe Larry will.

[Bobby Bartlett]

As this post notes, the cost/benefit analysis of share buyback programs is considerably more complex than Morgenson suggests. For another thoughtful critique of Morgenson's article from a corporate finance perspective, see Roger Ehrenberg's discussion at:

http://www.informationarbitrage.com/2006/11/the_nyt_on_shar.html

[rob cyran]

It seems you are misinterpreting what she is saying.

>>>>you can also weigh option costs another way — by analyzing how much money companies must spend to buy back shares that the granting of options creates. Amounts spent on these buybacks . . . reduce a company’s net worth. . . . <<<<

Let's use Dell as an example -
it has spent something like $20bn (sorry, don't have figures at my fingertips) buying back stock over the past five years. Last time I checked, about two-thirds of which went to mop up stock granted to executives.

A few points -

1. It seems reasonable to assume that since management had so many options, they prefered a buyback to a dividend policy.

2. As a shareholder, the only value of the two-thirds spent on buybacks to mop up option grants was to retain management. Could Dell have kept their execs if they paid less? I suspect so, in which case a large amount of shareholder's money was wasted.

3. There is an opportunity cost here- Dell has chosen to spend its free cash on buybacks rather than capex. Poor choice.

My point is similar to that of Morgenstern in her article. Designing compensation policies that favour one metric often causes execs to produce that metric (in the article's case EPS) no matter the economic cost. It's a bit like communist production targets for shoes. You'll get them, but they will be shoddy and the wrong size. Be careful what you ask for.