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San Francisco Chronicle



Is Coke's big move real thing?

Kathleen Pender


The San Francisco Chronicle



Copyright (c) 2002 ProQuest Information and Learning. All rights reserved.

Coca-Cola opened a new can of worms when it said it will hire two investment banks to put a market value on its employee stock options, which it will then deduct as an expense on its income statement.

Until now, the controversy over options centered on whether companies should expense them. With Coke's revelation, the dispute is spilling over into how companies should value options.

Some academics say Coke's valuation scheme could be an improvement over existing methods. But a group that opposes stock- option expensing says Coke's decision illustrates how "expensing stock options creates an opportunity to manipulate earnings."

Options give employees the right to buy company stock at a set price, known as the strike price, within a certain number of years. The strike price usually equals the stock's market price on the date of grant.

Companies can deduct the so-called fair value of employee stock options on the date of grant as an expense on their income statement. Or they can merely disclose the fair value in a footnote without deducting an expense.

The first treatment reduces reported earnings, the second does not. Not surprisingly, most companies chose the latter.

Among large companies, only Boeing and Winn-Dixie expense options. Last week, AMB Property of San Francisco joined the club. Coke followed suit on Sunday, followed by the Washington Post on Monday. Warren Buffett, an outspoken advocate of expensing, is a director and major shareholder of Coke and the Washington Post.


No matter which accounting treatment it chooses, a company still has to value options. Almost all use the Black-Scholes model, named after its Nobel Prize-winning creators, Fisher Black and Myron Scholes.

Companies plug a number of variables into the model, such as the option's strike price and time to expiration, the stock's current market price and dividend, expected interest rates in the future, and the stock's expected future volatility. The model spits out a hypothetical value.

Black-Scholes was designed to price stock options that trade on exchanges. Everyone agrees it's imperfect for valuing employee options, because they can't be traded and their life span is much longer than than tradable options.

Some variables -- namely expected interest rates and expected volatility -- are also highly subjective and open to manipulation.

But there is no distinct method for valuing employee options, so Black-Scholes became the default.

Coke had been using Black-Scholes to value options. In the future, it will get price quotes from two investment banks, reported to be Citibank and Morgan Stanley.

"We're going to ask each of them for a price to buy 10,000 options and sell 10,000 options, and then we will average those four prices," Coke spokeswoman Kari Bjorhus says. Those options will have the same features as the employees' options.

Coke will deduct one-fourth of the option expense each year because the options vest over four years.

Coke will only expense options granted this year and later. It will continue to show existing options only in a footnote.

If Coke had expensed stock options last year, its earnings per share would have been $1.51 instead of $1.60.


The company predicts that expensing options will reduce earnings by 1 cent per share this year, 3 cents next year, 5 cents in 2004 and 9 cents in 2005.

Under accounting rules, companies cannot reverse charges for options that are never exercised.

Coke's Bjorhus says the investment banks will give "a more accurate reflection of market value" than Black-Scholes would give. "The financial firm providing the quote would be obligated to fulfill that bid," she says.

Accounting rules merely state that a company must determine a Fair value for employee stock options. They don't prescribe or prohibit any valuation method, although they acknowledge Black-Scholes as one valuation method.

Some companies complain that Black-Scholes overvalues employee options.

On average, it might give a value that is 30 percent of the stock's market price on the date of grant, according to Sandra Sussman, executive director of the National Association of Stock Plan Professionals.

Ira Kay, a compensation consultant with Watson Wyatt, says the average is 40 to 50 percent, and can reach 80 to 90 percent.

The more volatile the stock, the higher the valuation. High-tech companies, which are big users of options, can also end up with high Black-Scholes valuations. That's one reason most high tech firms stridently oppose expensing options.


One accountant for a Big Four firm says Coke probably will get a lower valuation from investment banks than it would get using Black- Scholes because the banks "could apply some discount because the options aren't tradable."

The plan could create conflicts of interest. An investment bank might low-ball an option valuation with the hope of winning other business from the company.

Coke's plan "raises some concerns about the folks doing the valuations," says Anne Yerger, a spokeswoman for the Council of Institutional Investors.

"Is this better than not expensing options? Probably. Is this the best way to value them? Probably not," Yerger says. "No matter what the model, there has to be good disclosure of assumptions" that go into the valuation.

Steven Huddart, an accounting professor at Pennsylvania State University, says Coke may be taking a step in the right direction.

"Conceptually, what they're doing is well grounded in the economics of the transaction," he says. "A lot of financial accounting has been trying to move toward fair values. Those are obtained in ways similar to ways Coke seems to be using."

But Kim Boylan, an attorney with Mayer, Brown, Rowe & Maw who represents a group of companies opposed to stock-option expensing, says Coke's decision "shows the valuation issue is a problem."

She says if other companies choose other banks to value their options -- or come up with other ways -- investors could end up with a "mishmash" that would make it hard to compare companies. "This potentially will make (earnings) even more misleading. There's also the potential for manipulation. A company could shop around until they get a valuation they like," Boylan says.

She admits that Black-Scholes is also subject to manipulation. "I'm not a fan of Black-Scholes, but at least the basics of the model are the same."

Boylan says, "People should be focusing on the valuation issue. If enough people sit down and study it in a rational, objective manner, maybe a consensus can be reached. A quick fix is not going to help the markets."

Huddart agrees that options are difficult hard to value, "but that doesn't mean you should stick your head in the sand," he says. "Pretending the number is zero when the evidence is that it's not is, I think, wrong."

Copyright © 2000 Dow Jones & Company, Inc. All Rights Reserved.

Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
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