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The good and bad about options

Stock options have a hidden cost: The more that are out there, the less valuable the underlying stock becomes. And that hurts shareholders, especially shareholders in technology companies.

Shareholders of technology stocks have been battered by earnings shortfalls at their favorite companies and day-late downgrades from brokerage analysts. But a third element is at work in the current devastation of tech stocks, one that's less obvious but every bit as powerful. It is the ill effect on shareholders of enormous stock option grants.

Ira Kay, national director of compensation consulting at Watson Wyatt Worldwide, thinks corporate America's stock-option binge of recent years is a big contributor to the Nasdaq's plunge. "There are many factors going into the dramatic declines in the stock market," he said, "but it can't have helped the tech sector that so many companies had 40 percent or more of their shares reserved for stock options."

Kay bases his view on the results of a recent study by Watson Wyatt. It found that even before the Nasdaq fall, companies making the biggest option grants produced lower total returns to shareholders and higher levels of stock price volatility. The study, which examined option grants and stock price moves at 850 of the nation's largest companies, concluded that the heavy use of stock options had motivated executives to pursue riskier business strategies, such as adding debt and making high-priced stock buybacks. These moves produced bigger swings in the share prices, which are not in the best interests of stockholders.

Stock options became an addiction in the 1990s. Companies liked them because they did not have to be counted as an employee expense and they made earnings look better than they were. Employees liked them because they seemed to be the path to riches.

But options have a hidden cost: The more that are out there, the less valuable the underlying stock becomes, because options increase the number of shares that must compete for a company's earnings. This lowers earnings-per-share to stockholders.

The Watson Wyatt study examined the number of option grants made and future ones planned at each company. Then it compared these figures with the shares outstanding. Companies with a high percentage of unexercised options have option overhang.

The overhang has surged in recent years, Kay said. The average overhang for the 850 companies surveyed stood at 13 percent of outstanding shares, according to the latest figures, up from 9.2 percent in 1995. Volatility among these companies' stocks averaged 17.2 percent, up from 12.7 percent.

Technology companies have the greatest overhang, devoting an average of 23 percent of shares outstanding to option grants. That's double the percentage found in other sectors such as financial institutions and makers of consumer goods. The only sector that approached technology in overhang was health care, with a 17 percent average.

In 1998 and 1999, companies with high option overhang produced much lower total returns to shareholders than those with fewer option grants. The biggest grantors returned 7.4 percent, while the smallest returned 14.3 percent. Companies with medium overhang showed 17.8 percent gains over the two years.

Now, the bill for all those options is coming due. As it becomes clearer to shareholders that options exacerbated their stocks' declines, perhaps executives at companies with option excesses will be forced to rethink their strategy.

Kay said companies should encourage outright stock ownership instead of options. Companies that do so show higher returns to shareholders, have less volatile shares and pursue more balanced stock repurchases.

"When the Nasdaq rout ends, companies with the largest overhang will have corrected more than middle- and lower-overhang companies," Kay said. "It will be one of the explanatory factors."