When Is a Share Price Like a Jalopy?
from Summer 2000
by David Moon
It is easy to tell how a person values something-look at how preciously he or she treats it. In college, I was willing to lend my `68 Opel to anyone. Roommates, friends, strangers-it didn`t matter. I would leave the keys in the ignition when I parked the car. No self-respecting chop-shop operator would stoop to stealing that set of wheels. Eventually, I sold it for $60-and was embarrassed that I had taken advantage of the buyer. I was willing to practically give the car away, because I knew its true value: nothing.
It sometimes seems that many boards and executives place the same zero value on their stocks and stock options, which makes me wonder about the value of their companies-and how they compensate the help.
Stock options are one of the least understood and most abused tools of compensation in today`s boardrooms. Many incentive plans effectively treat corporate stock as if it is worthless. If you knew your company would generate a relatively shabby 5% total annual return over the next 10 years, would you heap rewards on your executives?
Merck & Co. will. In 1999, the drug maker issued 10-year options on 28.8 million shares of its common stock to company employees. In its proxy, Merck presented three scenarios-that over the next 10 years the stock value would increase at an annual rate of 0%, 5%, or 10%. If there is a zero increase, the employees get nothing, which is only fair.
But suppose it goes up 5% annually? After 10 years, Merck employees will realize a $1.4 billion gain on their options and CEO Raymond V. Gilmartin will make more than $20 million-all pretty lavish considering its shareholders could have done better with Treasury bills. If Merck`s stock price increases 10% annually, Gilmartin would realize a gain of more than $51 million on these options. Although Merck`s stock declined 8.9% in 1999, its 10-year average increase has been 17.9% annually.
Even worse is a board that treats its stock as if it has negative value. Hewlett-Packard CEO Carleton Fiorina (who, incidentally, also serves on the Merck board) is eligible to receive options for up to 25% less than the current market price of the stock. The other H-P board members, including outside directors, also qualify for this plan. In effect, these folks pick up fat rewards so long as they show up with a pulse-and provided the share price doesn`t fall by more than 25%.
Even though plenty of other companies have similar "incentive" stock option plans, a few are bucking the trend and trying to recognize the value of shareholders` capital. Consider Level 3 Communications, an international telecom headquartered in Bloomfield, Colorado. This company raises the strike price of its executives` options each year based on increases in the S&P 500. Unless the stock price of Level 3 outperforms the S&P 500 Index during the two years following the receipt of a particular option, that option is worthless. Director compensation also takes the form of these options.
Colgate-Palmolive`s stock option plan is even better. In 1997, CEO Reuben Mark received options with strike prices that were 10% to 70% higher than the then-market price of the stock. The bulk of Mark`s options don`t vest for five years, at which point they will expire worthless unless Colgate stock has increased in value by at least 70%. Unlike fixed-price options, which reward executives for mediocre performance, Colgate pays extraordinary compensation-but only for extraordinary performance.
Like my Opel, money declines in value over time. Any option with a fixed strike price ignores the time value of money, effectively rewarding the option holder for being the captain of a ship during a rising tide. Even a 5% savings account will grow 60% over 10 years. So why should an executive be rewarded for just watching the clock tick?
