Posted 12:21 AM by Robert

Warren Buffet and Options

Why does Warren Buffet keep making these same arguments about options , when they have been definitively answered?

Mr. Buffet continues to pretend that a sound and "honest" number can be chosen to represent the "expense" of employee options. But not even the FASB proposal which would require expensing options contemplates any such thing. Here's what the proposal says:

The fair value of a stock option or equivalent award would generally be estimated using an option-pricing model that considers the following factors:

* The current (grant date) price of the underlying stock;

* The expected volatility of the underlying stock (i.e., the expected variance of returns on the stock);

* The option or exercise price;

* The expected life of the option;

* Expected dividends on the stock; and

* The expected risk-free rate of return during the option life.

The proposed standard would not require use of a particular option- pricing model or approach, but does specifically identify Black-Scholes and binomial option pricing models as being appropriate. The method used to estimate fair value should explicitly incorporate each of the factors enumerated above. This is critical because the proposed accounting would require compensation expense and the value of the award be adjusted to reflect subsequent changes in the expected life of the option. To appropriately adjust for changes in this estimate, its role in the determination of fair value must be explicit. There are several relatively inexpensive software packages that value options based on user specification of these six input values. With the availability of these option-pricing packages, determining the appropriate assumptions to use as software inputs is expected to be the most difficult task in the valuation process.

So the FSAB proposal would allow companies to choose the pricing model. Which is fine, since most analysts would ignore whatever number was used anyway and substitute their own. For example, the comment above notes that the expected volatility of the underlying stock is key to determining the value of the option. Consider the behavior of the markets over the past few weeks. How comfortable does one feel that the "expected volatility of the underlying stock" could have been predicted - for any stock at all?


Mr. Buffet says: "I have a proposition: Berkshire Hathaway will sell you insurance, carpeting or any of our other products in exchange for options identical to those you grant yourselves."

That sounds nice. Suppose Mr. Buffet uses Black-Scholes to value the options in the trade. And suppose his counterparties choose another measure - a so-called "ex post measure." Well, one study has found that "based on a sample of 53 firms ... the Black-Scholes model overestimates compensation expense by approximately 39 percent relative to ex post measures." Mr. Buffet is a clear financial genius. And he will need every bit of that genius to close a 39 percent gap between asking and selling price for all that insurance, carpeting or other products.

And why in God's name does he keep saying things like "Chief executives frequently claim that options have no cost because their issuance is cashless?" If some CEO's are making the point in that crude, misleading language, Mr. Buffet should be campaigning for them to stop doing that and instead explain to their shareholders that options have dilutive effect that can be measured by different ways under different assumptions. But this is no excuse for Mr. Buffet to be urging his own misleading single-number, single-model misrepresentation as a replacement for another misrepresentation to which he objects.

Mr. Buffet has repeatedly and famously asked: "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?"

And the answers are pretty clear:

Options are a form of compensation that can be valued in different ways.

Compensation is an expense that can be given different dimensions depending on the model and assumptions chosen. And once those are chosen, " there are several relatively inexpensive software packages that value options based on user specification."

This kind of expense should go in a footnote to balance sheet earnings describing the alternative "pro forma" calculation of earnings using one or more options pricing models, together with an explanation that other models and assumptions can be used.

It is hard to understand why a mind as capacious and practical as Mr. Buffet's gets stuck on this odd little issue. It is not too hard to come up with various, unflattering and flattering possible motives for Mr. Buffet's position - but that would be speculation. The reader may speculate for hereself, if she wishes.

But whatever may be motivating Mr. Buffett, this issue sure isn't any part of what has the equities markets in a snit.