Man Without Qualities

Thursday, November 14, 2002

Another Warren Buffet Profession

The dust has mostly settled on the "expensing of options" issue - but the Man Without Qualities wants to kick that dust up a bit, in this case kick a bit of it in the direction of Warren Buffet.

As noted in prior posts, Warren Buffet has for some time taken the lead in advocating the "expensing" of options, a practice that Mr. Buffet professes to believe is required by "honest accounting."

Mr. Buffet repeatedly says or implies that public investors will value a company at a lower share price if the options are carried as an "expense." Let us accept that implication as fact for the sake of this post.

Mr. Buffet also makes clear in his public statements that his companies do not use options to compensate their senior managers, and, if a company has such options outstanding at the time the company is acquired by Berkshire Hathaway, they are generally eliminated and the stock option program terminated. Berkshire Hathaway routinely acquires a control position in companies in which it invests.

Mr. Buffet is particularly active in refuting the argument that options should not be expensed because they are hard to value. He notes correctly that there are several fairly standard ways of valuing options, and that Berkshire Hathaway does it all the time for companies it plans to acquire. Indeed, Mr. Buffet seems to favor valuing and expensing options at the time they are issued, and then carrying that expense on the company's books at that historic number until the options expire.

Consider how these various aspects of Mr. Buffet's approach interact:

If at a particualr point in time a public company not owned by Berkshire Hathaway had preiously issued substantial executive options, then under Mr. Buffet's proposal those options would have been valued and expensed at the time they were issued. Almost any such valuation technique will have depended on an evaluation of the expected performance of the company stock price, especially its volatility, over the life of the option.

Suppose, in this case, that the stock has not done as well as expected at the time the options were issued, so that at the particular point in time we are considering, an evaluation of the outstanding options would reveal that they are expected to be much more "out of the money" over the remaining portion of the option term than was expected at the time the options were issued. This means that the historical expense placed and carried on the books of the company for the options is substantially greater that the expected liability the options represent at the particular point in time with which we are now concerned.

In short, because of Mr. Buffet's proposal, the company's books understate its value by the amount of the difference between the historical expense and the actual liability corresponding to the options. Now, Mr. Buffet also says that public investors will in large measure be influenced by what expense appears on the company books. After all, if investors didn't care about what "expense" is carried on the company books, it would not have been necessary to reform the books to comply with "honest accounting" - as Mr. Buffet insists. Put another way: the company stock should trade at a price lower than would be the case if the "expense" were not so large. Now, Mr. Buffet also says that if Berkshire-Hathaway is considering buying the company, Berkshire-Hathaway will value the company and perform its own appraisal of the options liability.

So Mr. Buffet seems to be saying that if his "reform" proposal is adopted, Berkshire-Hathaway will be aware when a company it is considering acquiring is being undervalued by the public market - and that more such companies will exist than exist now.

Once Berkshire-Hathaway acquires the company, the options will be eliminated pursuant to Mr. Buffet's long-established policy. If the options can be eliminated for their actual value at the time of the acquisition, the elimination price will (by assumption) be less than the associated "expense" carried on the company books.

So Berkshire-Hathaway would pocket a nice profit right off the bat. (If the stock price of the company went up more than was expected at the time the options were issued, the options would be "underexpensed" on the company's books - and such a company would be less of a buying opportunity for Berkshire-Hathaway.)
Of course, this is all only true if Mr. Buffet is correct that markets care about whether an option is expensed or merely disclosed in a footnote. That is not something with which MWQ agrees.

But Mr. Buffet is an investments genius, and MWQ is not. So maybe he is right.

In sum: Berkshire-Hathaway buys companies disregarding the public book options "expense" which Mr. Buffet says the public market values the company's stock, in favor of Berkshire-Hathaway's own non-public valuation of that "expense." If Mr. Buffet is right, then his proposed "reform" to require the expensing of options seems to result in his acquiring the benefits of a refined and legal form of "stock fraud" and "trading on non-public information" through the operation of the very disclosure rules that are intended to prohibit anyone from benefiting from stock fraud and trading on non-public information .

Nice work, if you can get it. And Mr. Buffet certainly seems willing to try doggedly to get it. Is he just trying to do well by doing good?

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