As Stock Market Volatility Goes Up, Up and Away, the Use of Stock Options May Go Down for the Count - 24 Aug 2009 - F. Glassner

August 24, 2009

Options
have already experienced a decline in popularity in recent years thanks
to the onerous expensing issues of FAS 123(R), as well
as their lack of “line-of-sight” motivational impact on company
operational goals, but if you throw into the works the wrenches of
white-hot executive pay scrutiny, significantly declined capital
markets, as well as significant increases in volatility and
Black-Scholes
values, you have a potent witch’s brew indeed.

Not
being able to let this unique executive pay situation go
untouched, Veritas ran some quick calculations of volatility for the
Dow 30 stocks as follows:

MEDIAN ANNUAL VOLATILITY*:

                                                                                                        2009

                                                   2007            2008                 (1/1/2009-8/15/2009)

Median Annual Volatility              21.41%           48.81%                               41.07%

*Calculated on a daily basis using the adjusted closing stock prices

The not so surprising results confirmed that volatility had increased dramatically in 2008 and 2009 (through August 15) over 2007 – roughly 41% vs.
21.41% (based on daily volatility calculations using adjusted closing stock prices) - a whopping increase of approximately 100%!

To see how this dramatic increase in volatility might impact stock options, we then looked at volatility for the same group of
companies over two approximate 3-year
periods:

• 
  
  January 1, 2006 to August 15,
  2009; and
  
  


• January 1, 2005 to December 31, 2007.

Not
surprisingly, the rise in volatility that was illustrated in the prior
year-over-year comparison also echoed in the median 3-year
volatility calculations of 33.56% vs. 20.57% - an increase of
approximately 60%:

MEDIAN 3-YEAR
VOLATILITY**:

                                                                                                      2006-2009

                                                                          2005-2007                            (1/1/2006-8/15/2009)

Median Annual Volatility                               20.57%                                 33.56%

**Calculated on a weekly basis using the adjusted closing stock prices

So, you ask, how might this impact the future use of stock options?

• 
  
  Options have become very expensive indeed, and will become increasingly expensive to
  use;
  
  


• If capital markets are headed into (or are in) a prolonged bear mode (e.g., 1966-1982), there may
  not be much upside potential; and
  


• 
  
  The
  new government TARP bailout-related mandates being driven by "Executive
  Pay Czar" Ken
  Feinberg, that seem to be permeating executive pay overall, including
  harsh admonitions against “incentives that encourage excessive
  risk,” are also likely to have an adverse impact on the use of stock
  options.
  
  

Additionally, you may be thinking that, if stock prices begin to decline again, as compared to prior fiscal periods, wouldn’t
the impact of increased volatility be offset by the decrease in stock prices?

Just
to
satisfy our never-ending curiosity, Veritas took the closing median
stock price of the Dow 30 companies for each of the aforementioned
3-year
periods (for consistency, the 30 companies that were in the Dow at the
start 2005-2007 period were used for each
period):

• 
  
  $39.63 for January 1, 2006 to August 15,
  2009; and
  
  
  


• $39.74 for January 1, 2005 to December 31, 2007.

We then used most recent median FAS 123(R) assumptions disclosed for the Dow 30 and ran a Black-Scholes model of
what a “median” stock option would look like for each 3-year period:

• 
  
  Risk free interest rate of 4.80%;
  
  
  


• Dividend yield of 2.33%; and


• An expected life of 6.00 years.

The
results confirm that the relative cost of stock options will continue
to increase as a result of subsequent increases in volatility
for 2008 and 2009. Black-Scholes values were:

• 
  
  $12.76 (32.21% of face value/median stock price) for the 2006-2009 period; and
  
  


• $9.05 (22.77% of face value/median stock price) for the 2005-2007
  period.

That
represents an approximate 41% increase in face value/median stock price
– so even though stock price has dropped, the
Black-Scholes value has not, and the not so good news is that the FAS
123(R) cost of stock options (as a percentage of share price) will
continue to
increase:

MEDIAN MOST RECENTLY REPORTED FAS 123(R) ASSUMPTIONS***:

                                              Dividend                    Risk
Free              
Expected

                                                Yield                           Rate                 Option
Life            Volatility

Median FAS
123(R)                  
2.33%                         4.80%                 6.00 years              25.50%     Assumption

***For those Dow 30 companies reporting the use of stock options

INCREASE IN BLACK-SCHOLES VALUES:

                                             
Median                 
 Black-Scholes                % of
Face Value/

Time Period        
               Stock
Price                     
Value              Median Closing Stock Price

2005-2007           
                 $39.74                     
      $9.05                                  22.77%

2006-2009                                    $39.63                            $12.76                                32.21%         

Is this the death of stock options?

Probably not.

However, their increased cost, possible limited upside, white-hot levels of public scrutiny, and the new government
bailout-related mandate to avoid “excessive risk” in executive compensation programs that is rapidly becoming a national mantra
will cause a good number of both public and private companies to reconsider their use of stock options.

For
the remainder of 2009 and into the foreseeable future, the main focus
of attention will continue to be choice and design of
performance-based long-term incentive plans. Stock-option awards surged
during the 1990s market boom, fueling steep gains in executive pay
levels, but
also creating high levels of share overhang and subsequent dilution
and, after implementation of FAS 123(R), significant impact on
earnings.

The
recent decline of the stock market, combined with significant earnings
impact from option expensing, has really curtailed the use
of old fashioned time-vested stock options and restricted stock grants
and participation levels, and has created keen interest in
performance-based
long-term incentives such as cash-based performance shares and
performance units, as well as performance contingent restricted shares
(PCRS).

Both
thoughtful plan design, as well as moderation in grant and
participation levels, will be the key to avoiding stock option plan
nightmares. Options will certainly continue to serve as a vital element
in executive compensation programs; however, their significant focus on
short-term stock price movement and the vagaries of capital markets in
general can be mitigated and balanced by performance-based long-term
incentive
plan designs utilizing multiple vehicles that incorporate operational
and financial targets other than stock
price.

In
these challenging times it will be harder and harder to justify
leveraged incentives that result in greater upside potential than in
the case for shareholders whose equity participation has come the old
fashioned way – by buying full value
shares.

No
matter what we do, there has never been a greater need for well
defined, easily understood, and above all, equitable executive pay
that has crystal clear linkages to both short- and long-term company
performance.

*****************************************************************************************************************

Veritas Executive Compensation Consultants,
LLC. (“Veritas”) is a truly independent executive compensation consulting firm.

We
are independently owned, and have no entangling
relationships that create potential conflict of interest scenarios, may
attract the unwanted scrutiny of regulators, shareholders or the media,
or
create public outcry.

Veritas also
believes that public company Boards
of Directors and shareholders deserve higher standards of disclosure
that verify the independence of the executive compensation advice that
their
companies receive from their consulting firms. This disclosure will
assist in curing the terribly negative views that shareholders,
employees, the
media, and the American public have on executive pay.

Veritas goes
above and beyond to provide unbiased
executive compensation counsel. Since we are independently owned, we do
our job with utmost objectivity - without any entangling business
relationships.

Following
stringent best practice guidelines, Veritas
works directly with boards and compensation committees, while
maintaining outstanding levels of appropriate communication with senior
management.

Veritas promises no compromises in
presenting the innovative solutions at your command in the complicated arena of executive compensation.

We deliver the advice that you need to hear, with
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Visit us online at www.veritasecc.com, or contact our CEO Frank Glassner personally via phone at (415) 618-6060, or via email at fglassner@veritasecc.com. He’ll gladly answer any questions you might
have.