Eastern Railroad Discussion > Railroads - management's options "game"

The Board of Directors regularly issues options to management as part of their compensation package. In conjunction with stock buybacks, the result can be a transfer of earning power from the outside share holders to managers. Here's how it works, highly simplified.

The stock is trading at $50 a share. Manager Al is issued options on 100 shares at $50, good for 5 years, with the first exercise opportunity in two years. If the stock price goes down or stays the same, the options to buy at $50 are worthless. Many options distributions are in the thousands of shares, and holding options on multiple millions of shares isn't unusual. Al's interest is getting the share price up, just like the shareholder's interest.

If the stock goes to $60, you and Al exercise and buy the stock at $50 from the company, and sell it on the open market for $60. A lot of CSX options issued to management when the stock was in the $35-$40 range are worth big bucks now.

When the company buys back stock in the open market, it often borrows money. Interest on loans is deductible and cheap. The total number of shares in the market will drop. The proposed CSX buyback will cancel about 30 million shares.

All things being equal, the corporate earnings will be divided over fewer shares outstanding. That means the earnings per share will go up for the remaining shares. Which is often a metric on which senior management is graded. And for which more options on stock will be issued.

(That's one reason why I rant about the give backs from labor becoming an annual profit contribution year after year. Management knows the long game is harvesting profits year after year.)

Two different topics here.

One is the use of options to incentivize management. (Note that at some companies -- particularly in high-tech -- options are widely distributed and are not reserved only for the C-suite). If a stock trades at $50 a share, it's more likely that new options are issued at a substantially higher price in order to induce management to drive up the stock price. Therefore "out of the money" grants of options are the norm. Maybe the options will become "in the money" someday, maybe not.

The other topic is the proper ratio of equity and debt in a publicly traded company. Although there are debt-free companies, the finance professionals will tell you that some debt is generally a good thing because it multiplies the returns of the shareholders. Obviously too much debt is a bad thing. Companies that determine they're not in the sweet spot (wherever that is) between debt and equity will do things to rebalance. Buying back stock is one mechanism; sometimes it's done with cash on hand, sometimes it's done with newly issued debt.

The combination of these two mechanisms can indeed be perverted to unduly enrich top management. One would hope that the independent directors on the board or the largest shareholders in a company restrain the actions of top management.



Edited 2 time(s). Last edit at 07/20/17 13:26 by ctillnc.