Wednesday, April 2, 2014

$24 Billion Wealth Transfer?!

So David Winters is upset about the "biggest transfer of wealth from shareholders to management" in history.  According to Winters Coke's (KO) new 2014 Equity Plan may cause 14.2% dilution to shareholders over the next four years.

His calculation is that there are 4.4 billion shares outstanding so 14.2% of that is 625 million shares, and at $38/share, that's $24 billion of wealth that will be transferred directly from shareholders to management.

Of course this is ludicrous.  How can this much wealth transfer occur in a company like Coke?

This is where the 14.2% comes from (2014 KO proxy):

Expected Value Transfer and Dilution
The Compensation Committee and the Board also considered the expected shareowner value transfer and potential dilution that would result by adopting the 2014 Plan, including the policies of certain institutional investors and major proxy advisory firms. Potential dilution is calculated as shown below:

[shares underlying equity awards that may be made under the 2014 Plan] + [shares to be issued on exercise or settlement of
Potential Dilution=outstanding equity awards under the Prior Plans] + [Holdback Shares] (collectively, “Total Award Shares”)
[total number of issued and outstanding shares of Common Stock (excluding treasury shares)] + [Total Award

Actual dilution will depend on several factors, the most important of which is the type of awards made under the 2014 Plan. This is because the 2014 Plan uses a fungible share pool, under which each share issued pursuant to an option or SAR will reduce the number of shares available under the 2014 Plan by one share, and each share issued pursuant to awards other than options and SARs will reduce the number of shares available by five shares.

The Company expects to continue to grant a mix of stock options and full value awards, primarily in the form of PSUs, under the 2014 Plan. To illustrate the range of potential dilution, the table below shows potential dilution pursuant to the above formula based on 4,405,893,150 shares of Common Stock issued and outstanding as of February 24, 2014 and assuming that all authorized shares under the 2014 Plan are granted (i) 100% as stock options, (ii) at the current mix of approximately 60% stock options and 40% full value awards and (iii) 100% as full value awards.

Current 60%/40%
Mix of stockmix of stock
options/full value100% stockoptions and full100% full value
awardsoptionsvalue awardsawards
Potential Dilution16.8%14.2%10.0%

The problem with this comment is that much of this dilution is going to occur via stock options (in terms of number of shares), and a grant of stock options is not a direct transfer of wealth of the entire underlying amount to the employee who receives it.  For example, if the stock is trading at $38 and an option is offered at a $38 exercise price, the cost to KO (which is expensed) would be around $3.8/share granted, not the entire $38/share.

Here are the inputs to value the stock options from the 2013 10-K:

The fair value of our stock option grants is amortized over the vesting period, generally four years. The fair value of each option award is estimated on the grant date using a Black-Scholes-Merton option-pricing model. The weighted-average fair value of options granted during the past three years and the weighted-average assumptions used in the Black-Scholes-Merton option-pricing model for such grants were as follows:



Fair value of options at grant date



Dividend yield1
Expected volatility2
Risk-free interest rate3
Expected term of the option4
5 years

5 years

5 years

The dividend yield is the calculated yield on the Company's stock at the time of the grant.
Expected volatility is based on implied volatilities from traded options on the Company's stock, historical volatility of the Company's stock and other factors.
The risk-free interest rate for the period matching the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.
The expected term of the option represents the period of time that options granted are expected to be outstanding and is derived by analyzing historical exercise behavior.
If you plug the 2013 inputs into an option model, you will get a fair value of less than 10% (of the stock price).

But if the KO stock price goes up over the next five years and the option is exercised, KO will "sell" stock cheap and then buy it back (repurchase) high.  Assuming the stock price goes up 8%/year, which is the EPS growth target (so is a reasonable estimate of stock price appreciation over the long term), then it may actually end up costing KO $18/share.  Some will say the true cost of the option, then, is the difference between the exercise price and the market price at the time of exercise.  Never mind if that's right or not for now.

The 2014 Equity Plan is based on historic trends in equity grants.  They are just reloading the gun, so the 500 million shares doesn't really mean anything in terms of year-to-year grants.

For real dilution or wealth transfer effects, maybe it's better to just look at the historic burn rate for KO which is disclosed here in the proxy:

Historical Equity Award Granting Practices
In setting and recommending to shareowners the number of shares authorized under the 2014 Plan, the Compensation Committee and the Board considered the historical number of equity awards granted under the Prior Plans in the past two full years and the annual equity awards made in February 2014. In 2012, 2013 and year to date through February 20, 2014, the Company used approximately 60 million, 63 million and 73 million, respectively, of the shares authorized under the Prior Plans to make equity awards.

The Compensation Committee and the Board also considered the Company’s three-year average burn rate (2011-2013) of approximately 1.3%, which is lower than the industry thresholds established by certain major proxy advisory firms.

Based on historical granting practices and the recent trading price of the Common Stock, the 2014 Plan is expected to cover awards for approximately four years.

The burn rate is 1.3% for the three-years 2011-2013.  That is very far from a 14.2% dilution over four years that Winters talks about.  The 14.2% includes options already granted and are outstanding from previous years.

By the way, check this out from Goldman Sachs' equity compensation presentation of 2013:

Of course, it's not a good idea to bring in GS and other banks to defend KO; I can imagine the outcry of some folks (who think bankers are even more overpaid).  But Buffett is a large shareholder of GS and is well aware of this.  I also don't mind this stuff too much at financial firms as I tend to look at BPS growth over time, and all of this is reflected in shareholders' equity.   For example, if JPM has a high looking burn rate of 2.1% but has grown BPS in double digits, that's fine with me.

OK, back to KO.  KO's burn rate is 1.3%.  I don't know that there is anything in the proxy that indicates that the burn rate will be any higher going forward.  

Well, using this comment:
In setting and recommending to shareowners the number of shares authorized under the 2014 Plan, the Compensation Committee and the Board considered the historical number of equity awards granted under the Prior Plans in the past two full years and the annual equity awards made in February 2014. In 2012, 2013 and year to date through February 20, 2014, the Company used approximately 60 million, 63 million and 73 million, respectively, of the shares authorized under the Prior Plans to make equity awards.
We may conclude that the burn rate might rise to 1.5%/year.  But I don't know if that conclusion is correct. Setting up the plan and granting things from year to year are not the same thing; maybe they want to have enough shares to grant just in case.  I just took the 60 million, 63 million and 73 million and averaged them and then divided by 4.4 billion shares (actually, shares outstanding was 4.6 billion in 2012).

So using a 1.5% burn rate (and for simplicity let's just assume it is mostly options granted) and 8%/year increase in stock price over five years, that's 0.75% actual 'cost':  8%/year would make the stock price go up around 50% in five years, so at-the-money options granted will eventually be worth 50% of the stock price.  1.5% of outstanding shares in options are granted every year so that's 0.75% in total cost.  But since KO gets to deduct the difference between the exercise price and market price (at time of option exercise) for tax purposes, the after tax cost would be around 0.5%/year.

With the current stock price at $38/share, that's $0.19/share in total cost or actual 'dilution'.

2013 EPS was $1.90, so it comes to 10% of 2013 earnings.

Accounting treatment now is that the cost of stock options is expensed using an option model but the difference between exercise price and market value at the time of option exercise, although tax deductible, does not show up on the income statement as an expense but does show up in a reduction in shareholders' equity (so is a "wealth transfer" from shareholders to employees).

Anyway, the above is theoretical, using assumptions (1.5% burn rate, all options, 8%/year stock price appreciation etc.)

We can see what the actual cost was in the recent three years by looking at the 2013 10-K:

Stock option activity for all stock option plans for the year ended December 31, 2013, was as follows:
(In millions)

Exercise Price

Contractual Life
Intrinsic Value
(In millions)

Outstanding on January 1, 2013






Outstanding on December 31, 20131


5.82 years

Expected to vest at December 31, 2013


5.78 years

Exercisable on December 31, 2013


4.25 years

Includes 3 million stock option replacement awards in connection with our acquisition of CCE's former North America business in 2010. These options had a weighted-average exercise price of $18.02, and generally vest over 3 years and expire 10 years from the original date of grant.
The total intrinsic value of the options exercised was $815 million, $780 million and $631 million in 2013, 2012 and 2011, respectively. The total shares exercised were 53 million, 61 million and 65 million in 2013, 2012 and 2011, respectively.
The above table shows the intrinsic value of the options exercised in the past three years.  Intrinsic value, of course, is the difference between the exercise price of the option and the market price of the stock at time of exercise.  This is the tax deductible 'expense' (that is not expensed) that occurs when KO has to sell the shares to the option holder for a low price versus a higher market price.

The figure in 2013 was $815 million, which comes to $0.19/share using 4.4 billion shares outstanding, but after tax would come to $0.12/share.  So that's the wealth transfer that has occurred at KO in 2013 (sold shares cheap, bought back high).  That also comes to 0.5% of the market cap.

And by the way, $815 million compares to $46.9 billion of sales (1.7% of sales) and  $10.2 billion of operating income (8% of operating income).

There are 302 million options outstanding already.  Someone might see this as an $11 billion transfer of wealth, but you can see that the instrinsic value of the options is $3.6 billion (as of the end of 2013).  If all options outstanding were exercised at once and KO repurchased shares in the market to offset it (at the year-end price), it would cost KO $3.6 billion, and after tax $2.3 billion.  That's against a current market cap of $167 billion, or 1.4%.  That's a 1.4% transfer of wealth from KO shareholders to employees.

The above excludes full value awards, but since those are expensed one-for-one and the number of shares are a lot lower than those represented by options, I tend not to think that it's that much of an issue.

I understand the frustration with excessive executive compensation, but I really don't think this sort of hyperbole is productive.  To call this equity plan a $24 billion transfer of wealth is very misleading.   Speaking of hyperbole, the recent "market is rigged" comment seems like that too, which may be another post.

I know there have been issues in the past about the treatment of stock options.  I don't have a strong view on that (other than that is should be expensed) and that's really not the point of this post.

David Winters is a BRK-holding value investor and I have a high degree of respect for him but I sort of wish he didn't resort to this kind of soundbite-ism.  I know that's the way of the world now; people won't pay attention unless you can get the message out in 140 character or less or in four words ("the market is rigged"), and that's very unfortunate.  


  1. Winters may have been employing some hyperbole in his comments but Coca Cola's response has been much worse. Responding to a shareholder with $100 million in stock, Coca Cola put out a highly insulting press release written by one of their attorneys lecturing Winters on lemonade stands and entrepreneurship. Furthermore, Coca Cola management brags that shareholders are being "protected" from dilution by share repurchases when in fact there is no logical linkage between the decision to issue stock based compensation and the capital allocation decision regarding repurchase of shares.

    There has been hyperbole on both sides but Coca Cola's is worse. After all, Winters is an owner of the firm and Coca Cola management works for him and the rest of shareholders. Business results have been less than stellar yet executive offers continue to pull down very large compensation packages, both cash and equity based. I hope that Warren Buffett will respond to Winters, if not now maybe in response to a question at the Berkshire annual meeting.

    1. Well, I don't want to get into an argument about who made the worse comment/response. I don't want to defend a big company bureaucrat necessarily, but Coke's comment was directed, I think, at all shareholders to defend their equity plan and not a direct response to Winters.

      And yes, Coke says they are repurchasing shares to offset dilution, but so does GS, JPM and many other companies. I don't think there is anything wrong with that as long as we all understand what the cost of that is. I know Buffett made a comment a long time ago regarding share repurchases to offset options versus 'real' repurchases below intrinsic value to enhance value for shareholders. This is all true.

      As for Buffett's response, I think he will say that $24 billion wealth transfer is an exaggeration and it's nothing even close to that, and that Coke intends to grant equity incentives at the same pace they have always done for years.

      Maybe he will comment on stock options to employees in general, but his views probably hasn't changed much over the years.

      If you look at most of his equity holdings, they probably offer stock options and then repurchase shares in the market to offset dilution. He personally owns JPM and they do it too. As does XOM.

      Anyway, in that sense, I don't think there is anything at all that stands out with KO's proxy than anything else that has been happening for years.

      My guess is that a young analyst that works for Winters misread the "transfer" as a literal transfer of wealth from shareholders to employees, got overexcited and then it snowballed from there. I have no idea.

      But that table in the proxy was actually an attempt at fuller disclosure, but I guess in this case it backfired, lol...

      Anyway, I don't see any big deal here, and I don't think Buffett would either.

    2. Oh, and I think Buffett would say equity incentives are fine as long as they are "pay for performance", and I think his biggest problem in the late 1990s was that stock options weren't even expensed back then, and now they are. So I would guess that he would say that as long as they are earned and expensed and within reasonable limits, he is OK with it. That's my guess.

      When speaking of excessive compensation, he has always said that he is all for pay for performance, saying even that Jamie Dimon is grossly underpaid etc...

    3. I'm sure you have seen this quote from Buffett in the 1999 annual letter given your excellent recent series on Berkshire:

      " Of course, both option grants and repurchases may make sense -- but if that's the case, it's not because the two activities are logically related. Rationally, a company's decision to repurchase shares or to issue them should stand on its own feet. Just because stock has been issued to satisfy options -- or for any other reason -- does not mean that stock should be repurchased at a price above intrinsic value. Correspondingly, a stock that sells well below intrinsic value should be repurchased whether or not stock has previously been issued (or may be because of outstanding options). "

      So it is always interesting to see companies explicitly link the two and to try to assuage shareholder concerns about dilution by talking about repurchases. That's like saying to the owners, "yes we are diluting your interest but we will offset that by using your own money to purchase shares at any price to offset that dilution."

      Yes, many companies do this even ones that Buffett admires. My guess is that he just views this type of thing as endemic and aside from the annual letter and meeting where he has a very large soapbox, he isn't going to go to bat each time something like this happens which makes sense.

      Your point regarding the $24 billion being exaggerated is true and Winters should have been less dramatic about it. I think that his real issue, which is similar to mine as well as a Coca Cola shareholder, is the overly generous nature of the compensation program and the use of equity as part of that program. He also raises good points about a lack of predefined criteria related to performance. But you are correct - he shouldn't have exaggerated the claims since that tends to weaken the overall argument.

    4. Yes, I know Buffett's view on this. But I don't think anybody said they will repurchase shares "at any price". I do think that these companies understand what the total cost of all of this is. At some price, it won't make sense to repurchase shares (like Facebook and other high fliers). But KO has been repurchasing shares anyway which seems to indicate that they still think shares are trading under IV.

      Dimon did say, though, that he would be aggressive when JPM stock is cheap for share repurchases and less when the price is higher and that's the way they look at it, but he said "except for share repurchase to offset options". But even still, he didn't say they will offset dilution at above IV. He is probably willing to pay up to IV, but anything above that would have to be thought about carefully. The cost is easy to quantify so I don't think it's a big problem.

    5. The problem with an explicit linkage is that it does muddy the waters in terms of the underlying economics of two distinct decisions. And the public relations benefit of repurchasing shares to offset dilution is pretty powerful and can impact decision making with repurchases especially if a company thinks that way, as demonstrated by public statements.

      Coca Cola at least does not have a "mandatory" repurchase plan to mop up option dilution. Some companies have such mandates. For example, Expeditors has two repurchase plans - a discretionary plan and a mandatory plan. The mandatory plan requires all proceeds from option issuance to be used to purchase shares on the open market regardless of price. And Expeditors is otherwise a very well run company.

      I haven't done so but it would be interesting to go back to the late 90s to see if Coca Cola was repurchasing shares at the peak of the bubble in the stock. I might look into that.

      Again, thanks for this article and the many others you have written, especially the Berkshire series!

    6. KO repurchased $1.56B and $1.26B worth of shares in 1998 and 1997, in years when their free cash flow was $1.8B and $2.9B. So, Coke was spending a huge portion of free cash flow on share repurchases when the stock was trading around 50x earnings. Obviously, this is a different management team, however, the company's past record with regard to stopping repurchases at above intrinsic value is less than desirable.

    7. Good points. I don't disagree, but it's not that huge an issue for me.

      As for repurchasing shares in 1998 and 1997, I do remember scratching me head. Not to bend over backwards too much to defend management, but I think over time if you issue at the money options and then repurchase shares to cover it in the market, it will average out so that you are paying something close to IV; sometimes below, sometimes above. Of course, I would agree that it's preferable to always just buy under IV and not do anything over.

      But even if you did, over time it averages out so that you issue stock ATM (sometimes below IV, sometimes above IV) and then repurchase shares (sometimes below IV, sometimes above IV) so that net-net, you are paying a higher price than the exercise price, but that is driven by whatever IV growth is acheived by KO during that period. Again, this is only over time and through cycles.

      So that's one way of looking at it.

    8. Anonymous raised a lot of good points.

      Linkage makes no sense whatsoever. Issuing shares or options is a normal part of business (if you believe in share based compensation) whereas deployment of free cash flow should be based on highest return, whether it be growth capex, acquisitions or buybacks. E.g. If there is an acquisition available that could increase IV by 10%, who cares if the company don't buyback to offset 1% dilution.

      Of course, some believe options are not good ways to incentivize employees (I'm more inclined to agree with them). But that's a more complicated debate, one that I don't have the answer to. The broader issue, though, is that at most companies compensation is not based on "pay for performance" or what they believe would best incentivize employees, but rather what everyone else is doing (not to mention hiring consultants to come up with those numbers). Then there is the ridiculous practice of removing asset impairment, "non-recurring" or "extraordinary" expenses from calculation of EPS (or whatever metric you use as measurement of success), as is the case at KO. The worst is when the board is able to award whatever they want by discretion without any specific targets!

      I own a couple "Outsiders"-type companies: Morguard and Constellation Software. Both companies have CEOs with large equity stake and have achieved outstanding long-term shareholder return. They never dilute a single share with options. Both have share based compensation but everything is settled in cash. I get it's kind of the same thing vs. options, but my hypothesis is that there is connection between their compensation structure and their long-term success. Though it's hard to prove.

  2. It doesn’t matter if other companies are offering stock option compensation. This doesn’t justify that a company like Coke should do the same. With investment banking you have individuals (traders) that actually drive the bottom line so of course you want to incentivize them and prevent them from going to other firms with your business.

    It is unthinkable to even compare employees from Goldman Sachs to employees from Coke. A ham sandwich can run the operations at Coke. You don’t need “innovative” individuals to run a bloody factory line of creating liquid diabetes syrup and shipping it off to bottlers to mix with water. Why in the world are shareholders paying an additional 10% - 15% tax on their rightful earnings to management? You want employees to have the benefits of thinking like owners? Okay make them buy shares on the open market. This is a racket and if I were a larger shareholder I’ll have management bent over on a barrel.

    This is ridiculous no matter how you try to spin it. Just 1% dilution means you give up 10% of the company over the decade. Is this ransom money to prevent management from introducing a new coke formula? Pathetic!

    1. You're right. Just because others are doing it doesn't make it right. Buffett hates that too; doing something cuz others are doing it. But I wouldn't agree with your comment about GS employees vs. KO employees. You may be right about some unskilled or low-skilled workers on the factory floor, but sales, marketing and things like that can be a lot of hard, difficult work.

      In any case, as long as these things can be quantified, it shouldn't really be an issue. If they didn't offer stock incentives, then they would just be paying out more in cash bonuses and things like that.

      I am more interested in the quantity or amount of compensation and not so much the form of it.

      Way back when stock options were NOT expensed, yes, that was ridiculous because corporations had it both ways. They paid themselves really well and it didn't even show up on the income statement so they could show big (and bogus) earnings.

      I'm not really convinced, though, that if we convert the incentives to all cash that KO shareholders would be better off. That's hard to prove either way.

      Anyway, again, as long as it's all out there and we can see what the 'real' costs are and where the cash is going, I don't think it's a big deal.

      But anyway, I understand your frustration.

  3. David Winters says stuff every now and then that makes you wonder how well he understands what he is doing. In a Barron's interview a few years back, he was discussing PE valuations of Swatch & Richemont after backing out inventory, which makes very little sense.
    What's the valuation?
    Richemont has a lot of cash and inventory. If you believe, as I do, that business will continue to improve, the stock trades around 10 to 12 next year's earnings, excluding inventory.

    1. Regardging Swatch and Richemont, I think Winters is looking at the enterprise value. The inventory at these companies is very liquid, therefore it is similar to cash. I think that Winters backs that out in his enterprise value calculation. It will be very difficult to run a business without inventory, but perhaps there is excess inventory.

    2. Winters is not looking at enterprise value in the traditional sense. He is looking at enterprise value and then backing out the inventory and then comparing that number to earnings. You are correct that it makes no sense to do this and compare the earnings to other companies and that is my point. (It might be useful as a credit analysis tool but Winters is definitely not doing that).

      This relates to the original blog post on KO. It seems like what Winters is saying about KO and its compensation plan should make sense. The concept that managements are overpaid in a broad sense seems true and one could see how it would apply specifically to KO. But when you look at his actual argument and points that he is making, that "Coca Cola is gifting management 14.2% of the share capital of Coca-Cola, worth $24 billion at today’s share price", it it wrong. It is wrong in a way that makes me, at least, believe that either Winters doesn't really understand the details of what he is talking about or that he is exaggerating his claims in a way that make me question his integrity.

  4. One related problem was revealed in Coca Cola's response. They were trying to dampen the outrage by saying that the stock plan wasn't just for senior management but for over 6,000 employees. But that brings up the important question of whether tying compensation to the stock price for people without direct responsibility for the overall company makes any sense. For example, a manager responsible for syrup sales in Mexico City would realize totally arbitrary results by being paid in Coca Cola. That's true even if his individual performance goals were used to decide how many shares to grant. The performance of the stock has almost nothing to do with his personal performance. The CEO and top officers would see more of a direct correlation between their work and the performance of the stock, but only over long periods of time. I think that this is why Buffett has said in the past that Berkshire's next CEO may well be paid in part with options but that options would never be widely used at Berkshire to pay other managers. It would make zero sense to pay the CEO of Benjamin Moore or Nebraska Furniture Mart with Berkshire shares when these managers are responsible for only a small subset of Berkshire overall. The same type of logic applies to Coca Cola and every company.

    1. That's a good and valid question. SBUX was known to dish out options even to baristas in cafes.

      I personally don't see anything wrong with issuing stock incentives all the way down the ranks. You want everyone, even the ones sweeping the floors at night, to think about the company. For service companies, this is obvious; you want them to smile, right? And not just pay them minimum wage and treat them like crap.

      But even for non-customer-facing employees, I think it's OK as long as it's reasonable (and not too much). It's far better to have someone work for you who cares about the company. They will keep an eye out, for example.

      For BRK, it might be a little different as there are distinct, separate entities. The various divisions within Coke, though, still should exist for the most part in selling as many servings as possible around the world.

      Anyway, it's an interesting discussion for sure. I don't have very strong thoughts about it either way, but I have tended to like it when lower level employees are allowed some sort of participation.

    2. Well, I'd want the person sweeping the floors to think about how to clean the floors properly because that's what they can affect. So I'd pay them on how well they do their particular job and not on how the stock performs which is something they have zero influence on.

    3. There should be ways to tie compensation to performance in a way that doesn't involve options but still creates loyalty to the company and employees who wish the company well. I've always liked the idea of cash bonuses that employees can direct into stock purchases at a modest discount, say 5-10%. There is a big psychological difference between receiving an option grant and having the right to receive a cash bonus and choosing to instead direct the funds into a stock purchase. The discount would just be an added bonus.

    4. Yes, paying the guy to clean the floors without incentive makes sense in a big firm like KO. But I don't mind extending incentives for people who work that don't directly and immediately impact the stock price. I do believe in team effort so offering something down the ranks is fine with me, but how low will depend on the company. It just makes no sense to go all the way down for sure.

      As stocks at a discount, I think that's a good idea too and many firms do that. But then you still have the issue of the company having to issue stock at below intrinsic value, which sort of has a similar effect to repurchasing shares above intrinsic value etc...

      Anyway, I know this discussion can go on and on, but it's not one of the issues that I know much about...

  5. It is obvious not many people posting here ever ran a business. The first rule in owner operated businesses is never to give up a shred of equity. You want to incentive your manager? Easy just give them a % of the profits that they help contribute to bring in. Don't ever give someone a piece of the business that lasts in perpetuity.

    When you have a business like Coke that is mostly automated and the products basically sell themselves, why on earth do you spread the wealth around? That's the role of government not corporations. Most Coke shareholders are old and fat and don't realize they are being stolen from... well they probably don't care. What's going to happen to Coke is that future growth is going to slow down substantially and shareholders will feel the squeeze when the stock price is about the same 3 years from now since management will be skimming the growth.

    1. That's just me; everyone else is arguing against options. I never ran my own business so you are right about that, and I am probably way too liberal in my thinking about options/stock grants. But I have to say I have never really put too much thought into it. Stock options has been around for as long as I've been in the business; it's just a fact of listed company investing. You just quantify it and move on... or at least that's my approach.

      I don't know about KO, but a lot of this is based on competitive pressures too. I don't think anyone really just dishes out options just for fun, or to make everyone just feel good.

      I remember when Buffett had to become the chairman of Salomon. He hated the compensation there and tried to change it, but it didn't work. It just wasn't possible to just cut everyone's pay and expect everyone to stick around. Options are a competitive tool in some parts of the tech world, biotech etc... (often cuz they just didn't have money early on).

      So there is that factor too, although I don't know how that works in the soft drink world.

      Anyway, interesting discussion. I will be the first to admit that I spend very little time on compensation issues.

  6. Good Post. Clearly the $24Bn wealth transfer comment is misleading and I think you are fighting the good fight for truth and transparency here.

    This may be a bit 'jargony', but using 'ex post' and 'ex ante' would help clarify points in your post.

    When you said "But if the KO stock price goes up over the next five years and the option is exercised, KO will "sell" stock cheap and then buy it back (repurchase) high... it may actually end up costing KO $18/share. Some will say the true cost of the option, then, is the difference between the exercise price and the market price at the time of exercise."

    More technically, as a first level consideration, the true pre-tax EX POST cost of the option is in fact the difference between the exercise price and the market price at the time that the option is exercised (ignoring potential transaction costs of zero to up to a few percentage points associated with costs of issuing or repurchasing stock which is very structure dependent – say follow-on offerings vs issuing directly to employee). This is certainly not the ex ante cost (i.e. the cost right before the options are issued)--- traditionally valuation models like some sort BSM variant are used to estimate the ex ante cost. I believe the IRS actually uses the ex post cost as an allowable expense and hence ~1/3 of the ex post option cost is paid for by the govt (i.e. shareholders only pay for ~2/3 of the cost).

    Now there are second level considerations about how doling out options impacts employee behavior. In terms of adverse impacts-- undertaking activities to increase volatility above historical levels doesn't seem to apply here, nor does engineering a sale or 'merger of equals' to get immediate vesting.

    Possible downsides do include a bias away from dividends (why the market norm for management comp isn't to issue options whose strike prices have some sort of adjustment at each dividend is still a mystery to me) and dealing with underwater options (whether re-sets or employees leaving). There are probably other distortions here that I am not thinking of.

    I don't really know why companies think it makes sense to issue ATM options to compensate executives, when clearly the ex ante valuation methodologies for options are different than they are for stock. Period. If executives want some leverage to shareholder returns, why not issue deep in-the-money options (say strike = 50% of spot, for example). In such a case, the ex ante pricing of the option will tend to be dominated by the Intrinsic Value (i.e. underlying stock component) not the Time Value.

  7. I respect Winters less and less. He should not be one to talk about compensation. Just look at the expense ratios at his fund: 1.89% for the Investor Class shares and 1.64% Institutional Class. And he's only done OK for his investors relative to his benchmarks. He's more of a media hound and promoter.

  8. You invest $50 in a lemon aide stand. You get 10 shares, and the owner get's 10. Based on the expected revenue stream the stand is worth $100, but the owner decides to issue more shares. It cost him 5 cents to issue the shares, but he keeps them all. The shares were worth $5 a share. The value of the company did not change. So now the shares are worth $4.

    $10 was just transferred from you to the owner.

    Sometimes it really is just that simple.

    Oh, but you say that the company is now worth $150, so your shares are worth $6 Your investment is now worth $60. But it should be worth $75. That $15 was a transfer from you to the owner.

    Oh, but actually $30 was used when the shared were worth $6 to buy back 5 of his own shares. Then he turned around and issued options to himself. Which vested over 4 years, and with the options pricing cost the company far less then the value of the stock.

    Over 4 years, he does exercise all those grants. By that time the company is worth $200. Good news, your shares are now worth $10. His are worth $10 and everyone is happy and even. Except the company should be worth $230, plus the cost of the options.

    Options are grants are dilution. They are a transfer from current current owners to management (senior and/or mid-level). Plain and simple.

    1. There is no question about that. You can also pay yourself a $10 cash bonus, and that would dilute the value to an equity owner too. I guess this is why restaurant/bar investors never make money, all the profits are skimmed out so minority owners see nothing... (despite no stock options being granted)

      The question basically was if the actual wealth transfer at Coke was going to be $24 billion or not, and I think it's clear that it isn't.

  9. Hi,

    Great blog. Very informative. Need weeks to fully absorb all the useful information compiled by you.

    Can you tell me a few books on value investing that you've liked and preferred?



    1. Hi,

      I have an Amazon bookstore you can look at. I should update it more, but it does include most of my all-time favorite books...

  10. The difference between exercise price and buyback is simply a way to put expenses on the cash flow statement and keep expenses off the income statement. Unlike the previous poster I gained one hell-of-a-lot of admiration for Winters, despite his obvious overstated figures, for being willing to bring this up. Entitlements should not be a part of business in America. We pay these people enough to guarantee their great-great-great-great-great-great grandchildren will not be required to work for a living.

  11. Great article, BI. I've linked a discussion on SeekingAlpha to this article so that people can get a good breakdown behind the headlines.
    God bless!

  12. Has anyone compared the stock-based compensations of European companies in the same industry (Nestle, Unilever, etc.)? I remember Tom Russo saying he much preferred those over American counterparts because the option awards are far less ridiculous. I would love to sit down and look at this myself when I have time, but just wondering if anyone have done this analysis.

  13. Thanks for the post. I think about it similarly but find it really easy to think about it in a cash flow sense. For me, when I calculate owner's earnings, I just make an adjustment for how much a company spends to repurchase the shares that they have issued. Just using FCF as a proxy for owner's earnings for Coke, I get the following numbers:

    2011: FCF - $6,950, options expense - $918
    2012: FCF - $7,865, options expense - $922
    2013: FCF - $7,992, options expense - $828

    (I know our numbers are a little bit different, but I just use average prices over the year. I know your method is better, but this is good enough for me.)

    I think a lot of people would be (or at least would have been before this Wintergreen thing) surprised to know that Coke's (and pretty much every company's!) FCF is overstated by something like 10-15%. For me I just make sure to take that into account - the difference between $7.2 B in FCF and $8B obviously changes the price that I would be willing to pay for shares.

    1. Additionally, I think that this is a bigger deal on an aggregate basis. Here's a chart I look at every quarter, that show's aggregate shares outstanding for the S&P 500 (page 8, fixed universe):

      I read that as saying that on aggregate, companies in the S&P 500 have spent some huge amount of money on buybacks, but their total amount of shares have stayed the same through the cycle. I would be interested to hear what conclusion you would draw from that.

      My conclusion would be something to the effect of thinking that corporate FCF is probably very overstated. If I ran a business and paid all of my employees in stock options, my "owner's earnings" would look really good, but I would be losing my company, so I don't think those numbers would reflect true owner's earnings.

      If you think of the return of the stock market over the long-term as net income growth + dividend yield + buyback yield, I think a lot of people would put a lot of importance on that buyback yield number, where I would use something pretty close to 0%. With the dividend payout ratio historically at about 60% and now at closer to 30%, if buybacks don't materially reduce shares outstanding for the S&P, I think long-term stock market returns could be 1-2% lower than people think (ie instead of net income growth + 4% dividend yield in the old days, maybe net income growth + 2% dividend yield + 0-1% buyback yield now, with the money that would have gone to dividends spent on buying back options grants).

      I know this isn't super important if you're looking focusing on finding great companies, but I find it fun to think about.

    2. Thanks for the thoughts. All good points.
      As for dilution on individual companies, a lot of people just seem to adjust for shares issued without adding back cash proceeds from exercises, so might over adjust it.

      Your approach is good. Same thing, I guess, but you can also just assume only repurchase of option exercises using the option exercise proceeds, so whatever is not bought back is actual dilution and you adjust that on the growth rate that you use.

      Anyway, thanks for commenting.

  14. Hello kk,

    nothing to do with the current post... just wanted to tell you that you run a very, very good blog. What I appreciate is "intellectual honesty" you say when you know something, you say when you don't, keep it that way, too many wanna be experts in today's investment blogs.

  15. Hi ,
    I have a question please.
    When companies report diluted EPS , they calculate how much it would cost to buy back the shares exercised from in the money options adjusting for the tax benefit from the loss.
    For that calculation do they take into account the historical cost that has been expensed as premium in the P&L ?
    Obviously diluted EPS does not take into account the time value of out of the money options but thats different matter.


    1. You can google diluted EPS calculation for a better explanation, but for calculating diluted EPS the in-the-money options are assumed to be exercised and the case proceeds from that used to repurchase shares. Any shares issued above the number of shares repurchased is your 'dilution'. I don't think there is a tax factor adjustment to it (that happens when the options are actually exercised) and I don't think the expense of the options upon granting comes into play).

  16. Thanks for the reply.
    Got a good explanation here :

  17. Are you going to the BH meeting on 4/24/14?

    1. Hi, I would like to but I don't think I can as it's busy around here around that time.

  18. I got referred to your blog by a fellow linkedin Group member, and I have really enjoyed reading it. Hope you like my blog on value investing in India at . Would be obliged if you gave comments!

  19. If the reason for using equity based compensation is to align management's interests with shareholders, the current system of awarding annual grants of restricted stock and options is misguided. Executives should be awarded shares of the company stock only if they dramatically exceed expectations or gain promotion. That will give them a stronger incentive to drive the share price higher because they won't automatically be getting additional shares every year. Executives should be paid largely in cash, and encouraged to purchase company stock on the open market if they believe that they can drive its price higher. Think of how much companies could save by eliminating all the expenses involved in justifying these awards.


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