The rise of stock options as a method of compensating senior managers at large companies has been one of the most significant developments in corporate finance. Ever since the Clinton administration made it tax-efficient for companies to pay executives with stock options in the mid-1990s, there has been an explosion in the practice.
Warren Buffett (Trades, Portfolio) has long criticized the practice, however, arguing that it represents an egregious transfer of wealth from shareholders to managers. In his 1998 letter to shareholders of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), Buffett addressed the issue of stock-based compensation.
How stock options are like falling trees
One of the main reasons why stock-based compensation became so popular in the ’90s (and why it remains popular today) is because there is a school of thought that states stock options represent “free money,” as they do not incur a cash charge. Therefore, they are a superior way to reward managers than simply paying them high salaries.
Buffett disagrees to the point where he will mentally subtract the value of stock options from the value of any company he is considering investing in:
“Perhaps Bishop Berkeley — you may remember him as the philosopher who mused about trees falling in a forest when no one was around — would believe that an expense unseen by an accountant does not exist. Charlie and I, however, have trouble being philosophical about unrecorded costs. When we consider investing in an option-issuing company, we make an appropriate downward adjustment to reported earnings, simply subtracting an amount equal to what the company could have realized by publicly selling options of like quantity and structure. Similarly, if we contemplate an acquisition, we include in our evaluation the cost of replacing any option plan. Then, if we make a deal, we promptly take that cost out of hiding.”
Another reason why stock options are considered to be a great way to compensate managers is that it aligns their incentives with those of shareholders – the higher the stock price, the more the options are worth. The problem with this philosophy is that keeping a company’s share price up at all costs is not necessarily good for the long-term health of the business. It also incentivizes executives to focus on beating earnings expectations to the exclusion of all else, which can – on the margin – make them more likely to cut corners and spend less on things like capital expenditures.
This isn’t to say that every executive who receives stock options never acts in the long-term interests of their business – not at all. But I think it’s reasonable to suggest the practice does distort decision-making in marginal cases. It is exactly for this reason that Buffett does not require his managers to provide earnings targets, as he believes it makes them engage in precisely the kind of corner-cutting we have discussed. Companies need to be run in the interests of shareholders, not managers.
Disclosure: The author owns no stocks mentioned.
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This article first appeared on GuruFocus.