Impact of Employee Stock Options on Cash Flow

Exercise of stock options provides a source of operating cash flow because of the accounting treatment of reduced income tax payments. Tax savings from option exercises can generate a high percentage of a company's total operating cash flow, although this source of cash varies substantially among companies and from year to year. The net effect of option exercises on cash is a function of tax savings, exercise volume and depth, and funding policy. From 1999 through 2001, companies in the S&P 100 Index repurchased stock well in excess of option exercises whereas Nasdaq 100 Index companies tended to meet exercise demand with previously unissued shares. On average, Nasdaq 100 companies would have had to spend 39 cents of every dollar of revenue over the 1999–2001 time frame to fully fund option exercises and avoid increasing the number of shares outstanding. Cash flow effects of option exercises will remain an issue regardless of the expense treatment of stock option grants. Debates about the expense treatment of employee stock option grants have raged on for more than a decade, whereas the effect on cash flow of stock option exercises has gone virtually unnoticed. Income and expenses are important, but analysts generally consider cash flow a more reliable indicator of performance than accounting income. Operating cash flow is thought to represent a relatively “clean” measure of performance. Thus, if option exercises have large effects on cash flows in general and on operating cash flow in particular, the understanding and evaluation of these effects are critical for analysts.Using data from companies in the S&P 100 Index and the Nasdaq 100 Index, we examined the impact on cash flow of the exercise of employee stock options from 1999 through 2001. Stock option exercises provide a source of operating cash flow because they are an expense that reduces taxable income. This situation is strange because options are not required to be expensed for financial reporting purposes. Furthermore, the tax savings from option exercises can generate a high percentage of a company's total operating cash flow, although this source of cash varies substantially among companies and from year to year. Microsoft Corporation, for example, had more than $5 billion in tax savings from option exercises in 1999—nearly half of its operating cash flow. By 2001, however, the company's tax savings had dropped to about 11 percent of cash flow.Option exercises' net effect on cash is a function of tax savings, exercise volume and depth, and funding policy. For 1999–2001, companies in the S&P 100 repurchased stock well in excess of option exercises whereas Nasdaq 100 companies tended to meet exercise demand with previously unissued shares. On average, Nasdaq 100 companies would have had to spend 39 cents of every dollar of revenue during the 1999–2001 period to fully fund option exercises and avoid increasing the number of shares outstanding. Because the majority of Nasdaq 100 companies did not repurchase any shares in this period, the result was a growth in the number of shares outstanding from option exercises for most Nasdaq 100 companies. In contrast, most S&P 100 companies experienced no significant growth in shares outstanding from option exercises.Growth in shares outstanding is not necessarily evidence that shareholders are being harmed. Along with understanding how option exercises can affect operating cash flow, analysts should evaluate whether a company's option-funding policy is consistent with value creation. If a company has abundant investment opportunities, then investing in those projects might be more prudent than repurchasing shares. The differences in the S&P 100 and Nasdaq 100 companies' funding policies for options are consistent with differences in the investment opportunities for different sectors of the economy.Option exercises can claim a large percentage of revenues, and options have real cash costs. Regardless of what happens to the expense treatment of stock option grants, the impact on cash flows when employees exercise their stock options will remain. Thus, analyzing the effect of option exercises focuses the debate on a lasting concern in valuation.