Analysts Ignoring Cost of Stock Options

Some Wall Street analysts are failing to figure the cost of stock options in their reports to investors, at least so far.

Public companies last month were required for the first time to account for stock options as expenses, lowering their bottom line. For some companies, those new figures will be reflected in regulatory reports due soon, but stock analysts are not following suit, the Wall Street Journal reported.

Analysts are leaving out the information in earnings-per-share figures included in reports to investors. For example, Microsoft Corp. factored in the cost of stock options in its earnings outlook issued in April. However, only 15 of 29 analysts who cover the software company included the effect of stock-option expensing into their earnings estimates. The difference for 2006 earnings per share? Without expensing, $1.42; with expensing, $1.30.

Analysts told the Journal that they are being pressed to produce the higher earnings-per-share numbers by managers of mutual funds, pension plans and other institutional investors who oppose options-expensing. Those investors worry that the lower earnings forecast would reduce the value of stocks they already own.

"We're in the client-service business, and the majority of our clients tell us they prefer a pro forma number without the options impact in there," said Michael Masdea, a semiconductor stock analyst for Credit Suisse First Boston, part of Credit Suisse Group.

Some companies - Bear Stearns Cos. and UBS Securities - are trying to limit confusion by requiring analysts to consider the cost of options. However, Thomson Financial, PLC's Reuters Estimates and Zacks Investment Research are producing consensus earnings estimates determined by how a majority of analysts calculate corporate earnings. Therefore, if most analysts ignore the cost of options expensing when making earnings predictions, those estimates are eliminated from the consensus calculation.

Analyst Amrit Tewary, who follows semiconductor stocks for Standard & Poor's Equity Research, said in BusinessWeek that investors need to educate themselves about the impact of mandatory option expensing on future earnings. Not only will reported earnings be diluted, but they will not be comparable to prior periods.

Meanwhile, many companies are reacting to the new accounting standard by lowering the number of stock options they make available to their employees, according to Deloitte, which surveyed more than 340 firms during the second quarter of this year. While 75 percent of respondents are reducing the number of options granted, 91 percent said they would not make changes for senior executives.

"As a result, it appears that it will be lower-level employees who will take the biggest hit, as options seem to be reverting to their former use as compensation mainly for management," said Mike Kesner, a principal with Deloitte Consulting LLP and leader of the Executive Compensation Practice, in a statement.

The new rules have eliminated the primary advantage of stock options. Because they must be expensed, all forms of equity compensation are equal. “Now, human resources professionals are going to be spending a lot of time identifying the next generation of employee compensation," Kesner said.

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