The new Business Week (subscription required) has a column predicting woe for Agilent. Its argument is that implementation of the new rule requiring that stock options be treated as expenses will whack Agilent’s earnings by over 50%. At the present stock price, this will make Agilent’s Price/Earnings ratio 84 (outrageous!) instead of its current 34 (a mere very rich). Thus, the article implies, investors who look only at the PE ratio will dump the stock, sending the price down. And justly so.

I see it somewhat differently. Agilent is an interesting company (I better think so - my 401(k) contains a bit of it). It was spun off from Hewlett Packard in 1999 and contains the test-and-measurement business that was the origin of that great company. It also has a venture capital division, and is selling off its semiconductor manufacturing operations.

In sum, Agilent is a company that lives on the creativity of its workers. The BW columnist is stuck in 19th century model wherein I, as a shareholder capitalist, own the company, and the workers toil for wages. But I know nothing about test and measurement, so I find rather quaint the idea that a bunch of brilliant techies should be willing to devote their working lives to risky projects in the hope of making we shareholders rich while they get only salaries.

Rather, I see this as a partnership. I gamble a bit of money. The techies gamble their time, energy, and creative spark. If some of their ideas are successful, we share the gains. The way to do this is to give them options to buy stock. They could just get stock directly, but that would be worse for me. With options, were the company to go belly up we financiers would get whatever was left, without having to share with the workers. If the workers got straight-up stock, they would share in this residual value.

Furthermore, if they got stock then they would share in the earnings regardless of the success of their ideas. And, by creating stock options, I give the workers strong incentives to stick around and make the ideas work. Options also create a we’re-all-in-this spirit among the workers, who know that they sink or swim together.

There is no good way to value these options. Lots of people tell you it is easy, but they are not truthful, as Alan Reynolds has explained. The value depends on the capitalization that Mr. Stock Market ultimately puts on the future earnings that will flow from the techies' ideas, if they pan out. Whatever value FASB says to put on this imponderable is simply irrelevant noise. In fact, sophisticated investors are telling their financial advisors that they want the FASB-mandated options expense numbers removed so as to provide a better picture of a company’s profitability.

This instruction represents good common sense. Agilent has about 500 million shares out. Suppose it earns $500 million dollars next year, and gives out options on 50 million shares. It makes no sense to pretend that the company did not earn $500 million on its operations. It did earn it. Now, it is important to know that the $500 million must be spread over 550 million shares rather than 500 million. And it is important to know that if the earnings go up – and with them, the stock price – my gains will be diluted by sharing with the option holders. But I already knew both these things under the old accounting rules. Indeed, one of my criteria when buying a stock is whether the employees share in the stock’s gains, and thus have an interest in fostering such gains instead of lazing around the office rec center.

So the hedge fund sharks hope that lots of people read the BW story and sell out, so they can pick up shares on the cheap. Because ultimately it is the earning power of the brains at Agilent that they are counting on, and the delusions of the bean counters have nothing to do with it. Come to think of it, I am making a list of my own of companies that are likely to take an apparent earnings hit from the new rule.

So once again the government is playing reverse Robin Hood, taking from the poor and giving to the rich (less 10% for handling). The unsophisticated investors will mis-value the tech companies and sell out, and the sophisticates will pick up the bargains.

As the joke goes, "They're from the Federal Government, and they're here to help you." As a final joke, the category "sophisticates" includes Congressmen and women, who have access to excellent financial advice.

posted by James DeLong @ 8:21 AM |

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