48: Buffett On Stock Options; Negative Compounding
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Buffett’s Options Logic
In this video from the 1998 Berkshire Hathway annual meeting, Warren Buffett walks through his logic on stock options. While Berkshire does not issue stock options as part of its compensation programs, some of the companies in which Berkshire invests do. It’s important for Buffett to understand the effect of these options, as they act as a sort of negative compounding or deduction from the earnings to which owners are entitled.
If a business issues stock options equal to 1% of shares outstanding on average each year, that’s like an ownership tax placed on shareholders. A 10% return on shareholders’ equity with a 1% drag from stock options issuance means an effective return of 9%. Buffett rightly pays close attention to this.
Prior to 2006, stock options weren’t required to be expensed on the income statement. That situation prompted this famous quote from Buffett:
“If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses should not go into the calculation of earnings, where in the world should they go?” - Warren Buffett
While stock options are now expensed, Buffett’s logic remains as a great check on the sometimes unnecessarily complicated option/RSU/PSU schemes dreamt up by compensation consultants.
So how did Buffett adjust his valuation calculations? Very simply and logically:
Determine the average option issuance.
Determine how much those options would be worth as warrants if issued to the public.
That’s it. That’s the cost to shareholders of options given to management and employees as compensation.
Buffett goes on to explain when options are appropriate and how they should be priced. In short:
The recipient should have responsibility for the entire enterprise.
The price should be no lower than the then-current intrinsic value.
There should be a cost of capital tied to the option.
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Stay rational! —Adam
