Option Valuation: Mark Thoma v. the National Review

Thomas E. Nugent & Robert F. Clarke defend CEO compensation in part by claiming that the granting of employee stock options is like handing out free money. He notes the compensation package of the retired chairman of Exxon Mobil, Lee Raymond:

On this last point, options are typically granted from time to time at an exercise price equal to the market price of the stock on the date of the grant. At some point (often after 10 years), the options must be exercised, or they will be forfeited … But here’s what’s most important: In this example, the company paid the CEO a total of $12.5 million – not $69.7 million. The $57.2 million difference is a gain in the value of the shares earned by this CEO’s stewardship of the company. Importantly, the rest of the company’s shareholders (including, but not limited to, your pension plan and your mother’s trust fund) realized the same proportionate gain.

Mark Thoma reads this sentence, watches his head explode, but manages to put himself back together to write something a lot more coherent:

You are the CEO of a company but instead of paying you in cash, the company gives you an option to buy, say, 1,000 shares of stock any time during the next ten years at the current $100 price ($100,000 total). Over the next ten years, suppose the price of the stock increases to $250 so the 1,000 shares are worth $250,000 and the CEO exercises the option at the end of the ten year period. The easiest way to think about this is to imagine the company going out and buying the stock on the market at $250 per share at the end of the ten year period (if it purchased them in the past, the $250 is still the opportunity cost). Since the company receives $100 per share from the CEO, the option price, the company loses $150 per share, or $150,000. The argument is that “compensating [CEOs] … has not come at the expense of company profits.” Where do the writers of this commentary think the money comes from if it isn’t from the company’s bottom line?

Given the fact that companies often avoid stock dilution by purchasing shares when employees exercise these options, there is indeed a cash outflow as Mark suggests. While Mark follows Nugent & Clarke in terms of looking at the ex post value of the options, let’s use this Black-Scholes calculator to think in terms of the ex ante value of an option with a 10-year term. If the strike price equals the initial market price of the shares, which is $100 in Mark’s example, and if we assume no dividends, an interest rate of 5%, and volatility = 20 (ConocoPhillip’s 10-K was suggesting 22.5), the ex ante value of these options would be around $45. Not exactly a free lunch – is it? Now if you read carefully, the 10-K filing I was using, you might have noticed that the expected life of ConocoPhillip’s options were 7.18 not 10 so maybe we should assume an option price of only $37. You might have also noticed that these types of companies pay out dividends to shareholders to the shareholders, so that the simple Black-Scholes equation overstates the true value of these options.

But if Nugent & Clarke think that issuing options to CEOs does not have a cost to the shareholders of the company, there are not qualified to write about executive compensation. Which is of course why they get to write for the National Review.