I am sometimes accused of not doing my homework or glossing over some important details. I have a long history of the former stretching back to primary school days and I occasionally plead guilty to the second.
This article in the Toronto Star caught my eye today.
http://www.thestar.com/business/article/914809--academics-critical-of-skyrocketing-pay-for-ceos?bn=1
I will not take issue with the view that CEO pay has skyrocketted....it clearly has. I don't know at what level a CEO's pay is excessive....is it twice the national average or 300 times the national average. There must be a dividing line in there somewhere but I don't know where it is.
I take issue with one particular point in this article which states:
"The CEO pay figures may even be underestimated owing to a change in the way stock option compensation is reported, according to the report. Corporations used to report the amount of income that executives actually realized when they cashed in their options. Beginning in 2008, rather than reporting the amount their executives realized during the year by cashing in options, they reported a statistical estimate of what the options might have been worth in the market when they were granted”.
Let me explain why this particular point is so unsavoury to me. Stock options are typically granted such that the "strike price" is higher than the current stock price. So an executive who receives options that expire in 5 years with a current stock price of $50 dollars might have options with a 'strike price' of $75. This means that in 5 years the options are worth something only if the the stock is trading above $75.00.
So what is this option worth today if the stock price needs to rise by 50% plus a penny for the option to be worth a penny?? The tax code treats them as if they are worth nothing today and value is assessed at expiry. If the options are "exercised" due to a price that is higher than the strike price in 5 years, then the value above the strike price is treated as income. This is the actual cash that the executive receives and as such makes sense.
However is it really fair to say that an exec who receives one million stock options today has received nothing? If so many people would be volunteering to receive many such nothings.
Valuing these options is not easy. The key factor in determining the "fair value" on the date of issue is the volatility of the underlying stock. A stock that is very very low in volatility is less likely to rally by 50% than a stock that is very very volatile.
The formula for valuing these options is called Black-Scholes.
By assessing the value of the options and attributing that to the executive's income in the year in which it is granted, a more accurate picture of the exec's income for the year comes into focus. This does not cause the exec's earnings to be understated. On the contrary, it would be higher than if only the cash income was counted.
Additionally, such deferred compensation (which only yields cash after a significant increase in share price) aligns the CEO's financial well being with the long term interests of the shareholders. It is good for corporate governance and should be encouraged rather than used to make a false point about CEO pay.
Not every reader of the newspaper has worked as an options market maker, and the author of the article clearly hasn't either, however it would not have taken much to get the right background on stock options.
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