1999: How does Buffett adjust earnings for stock options?

WARREN BUFFETT: The question about how we charge for stock options is very simple. If we look at what a company issues in options over, say, a five-year period and divide by fives — because the grants are irregular — or whatever’s — if there’s some reason why that seems inappropriate, we might use something else.

But we try to figure out what the average option issuance is going to be. And then we say to ourselves, “How much could the company have received for those options if they’d sold them as warrants to the public?”

I mean, they can sell me options on any company in the world. I’ll pay some price for an option on anything.

And we would look at what the fair market value of those options would be that day if they were transferable options. Now, they aren’t transferable. But they also — employees sometimes get their options repriced downward, which you don’t get if you have public options.

So, we say that the cost to the shareholder of issuing the options is about what could be received if they sold — turned those options into warrants — and sold them public or sold them as options.

And that’s the cost. I mean, it’s a compensation cost.

And just try going to a company that’s had a lot of options grants every year and tell them you’re going to quit giving the options and pay people the same amount of money. They’ll say, “You took away part of my earnings.”

And we say, if you’ve taken away part of the earnings, then let’s show it in the income account and show it as a cost. Because it is a cost.

And I think, actually, a number of auditors agreed to that position many years ago. And they started receiving pressure from their clients who said, “Gee, you know, that might hurt our earnings if we reported that cost.”

And the auditors caved. And they put pressure on Congress when it came up a few years ago. And I think it’s a scandal. But it’s happened.

We are going to — in evaluating a business, whether we’re going to buy the entire business or whether we’re going to buy part of it — we’re going to figure out how much it’s costing us to issue — and when the company issues those options every year.

And if they reprice them, we’re going to figure how much that particular policy costs us. And that is coming out of our pocket as investors. And I think people are quite foolish if they ignore that.

I don’t think it’s going to change. It’s too much in corporate America’s interest to keep it out of the income account and keep issuing more and more options percentage-wise, and not have it hit the income account, and to reprice when stocks go down. But that doesn’t make it right.

Charlie?

CHARLIE MUNGER: Yeah, I go so far as to say it’s fundamentally wrong not to have rational, honest accounting in big American corporations.

And it’s very important not to let little corruptions start, because they become big corruptions. And then you have vested interest that fight to perpetuate them.

Surely, there are a lot of wonderful companies that issue stock options. And that stock options go to a lot of wonderful employees that are really earning them. But all that said, the accounting in America is corrupt. And it is not a good idea to have corrupt accounting.

WARREN BUFFETT: You can see the problem of the creep in it, once it starts.

It’s much like campaign finance reform. I mean, if you let it go for a long time, the system becomes so embedded and the participants become so dependent upon it, that there becomes a huge constituency that will fight like the very devil to prevent any change, regardless of the logic of the situation.

I mean, once you get a significant number of important players benefiting from any kind of corruption in any kind of system, you’re going to have a terrible time changing it. That’s why, you know, it should be changed early.

And it would’ve been easier to change the accounting for stock options some decades back when it was first proposed, than now. Because, you know, basically corporate America’s hooked on it.

This does not mean that we are against options, per se. If Charlie and I die tonight and you had two new faces up here who didn’t have the benefit of having bought a lot of Berkshire a long time ago, and they had responsibility for the whole enterprise, it would not be inappropriate to pay them in some way that was reflective of the prosperity of the whole enterprise.

I mean, they would — it would be crazy to pay the people at Dairy Queen in options of Berkshire Hathaway or pay the people at Star Furniture or any one of our operations, because they have responsibility for a given unit. And what the price of Coca-Cola stock does could swamp their efforts in either direction. It just would be inappropriate.

But it would not be inappropriate to pay somebody that’s got the responsibility for all of Berkshire in a way that reflected the prosperity of all of Berkshire.

And a properly designed option system, which would be much different than the ones you see, because it’d be much more rational, could well make sense for one or two people that had the responsibility for this whole place.

Charlie and I aren’t interested in that. But I think that you may be looking at two people up here, 50 years from now, I hope, where it would be appropriate.

But any option system, A, should not involve giving an option of less than the place could be sold for today, regardless of the market price. Because once management’s in control, they can make that decision. And it should reflect the cost of capital. And very, very few systems reflect the cost of capital.

But if we’re going to sit here and plow all the money back every year into the business and, in effect, use your earnings, interest-free, to increase our own earnings in the future, we think there has to be a cost of capital to have a properly designed option system.

People aren’t interested in that. The option consultants aren’t interested in that, because that isn’t what their clientele wants.

Charlie, you’re probably wound up a little more now on this, too?

CHARLIE MUNGER: No, I’ve wound up enough.

WARREN BUFFETT: OK. (Laughter)