Page 442 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

428 The Complete Guide to Executive Compensation

originally intended. It is this very movement of stock prices that causes the most problems
with the multiple approach.
The advantages of the exercise-cost method are its ease of use and ease of getting
competitive market data. The disadvantages include problems in adjusting during rising and
falling stock prices, ignoring growth potential differences from one company to another,
and difficulty in comparing company value with other present or future value compensation
programs.
Historical value is the second possible method for determining the number of shares to
grant. Easier than predicting what an option might be worth is examining on a retrospective
basis what previous options have been worth. This is especially important in studies of com-
petitive total compensation packages. Unfortunately, even here there is considerable debate
as to the correct approach. The possibilities include (1) total gain between selling price and
option price and (2) spread between option price and fair market value on date of exercise.
The more troublesome of these two approaches is the first, utilizing total gain between
selling price and option price. The complications of tracking options over varying time
intervals and attempting to relate their gain to a specified time frame are awesome, but more
important, it may be inappropriate. Once the executive has received the stock, when to sell
is the individual’s decision (except for the six-month limitation imposed on insiders); thus, the
person is like any other stockholder in the company. In retrospect, the decision to sell
may run the gamut from propitious to disastrous. Nonetheless, the selling decision is not a
function of the executive compensation program.
Admittedly, using the spread between fair market value and option price on date of
exercise as the basis for measurement has the logic of being consistent with tax rules.
Unfortunately, the problem of using total gain is also a factor here. Since the date of exercise
(within certain limitations of the grant) is at the discretion of the executive, it too is a market
investment decision (similar to selling). In retrospect, the amount of the gain may either be
overstated or minuscule in relation to the total gain (if any) realized at time of sale. The
argument for using this approach is threefold: (1) the appreciation is real, (2) it is directly a
function of the form of compensation, and (3) presumably, the executive is exercising at the
point in time believed to be most advantageous.
Intrinsic value is the third possible approach. It is the difference between the stock price
on date of grant and the price to be paid by the individual. If the stock option is granted at
fair market value, the difference is zero. This was the underlying principle of APB 25’s
measurement date principle.
Future value is a fourth possible approach. It simply calculates the spread between
options granted and the fair market value at the end of a prescribed period. The advantages
include a look-forward rather than a look-back factor and the ability to differentiate on grant
potential. The disadvantages include being more difficult and complex to calculate as well as
more difficult to find market data.
Using Table 8-17, one can approximate the future value of a stock option. For example,
if an option granted at $100 a share is estimated to grow at 10 percent a year, it should be
worth $33 a share after three years (i.e., $133 100). This is useful when comparing the
option to another long-term plan that is expected to run three years (e.g., a performance-unit
or performance share plan as will be described later in this chapter). Sometimes the Rule of
72 is helpful. As a rough guide, a value will double when interest times years equals 72. For
example, if one wanted to double one’s investment in eight years, one would need a 9 percent
annual compound growth rate.