Higher Employee Options Spur Stock Volatility

November 17, 2000 (PLANSPONSOR.com) - Companies with a high percentage of employee stock options usage experience dramatically increased levels of stock price volatility, according to a new study. However, firms with a larger direct employee ownership of shares fare much better.

In fact, the study by consultant Watson Wyatt Worldwide found that firms with a high degree of overhang saw their stock price volatility swing from 15% in 1997 to 17.9% in 1999.

On the other hand, during the same period, stock price volatility at low ownership firms grew at an annual rate of more than 13%, compared with a mere 4.5% at firms with high employee ownership.

“Hanging” Around

The measure of stock option usage is called “overhang,” defined as stock options granted, plus those remaining to be granted, as a percentage of the total shares outstanding at a given company.  Overhang has grown dramatically over the past decade – to an average of 13% at a typical firm – because of much larger executive option grants and increased option eligibility.

However, the rate in increase in overhang has slowed over the past two years.  Watson Wyatt noted that nearly 40% of the companies in their sampling had decreased their overhang since 1997, though those most likely to decrease had above-average overhang rates in 1997.

Risky Schemes?

On balance, the increase in overhang has had a positive impact on company performance, the overall U.S. economy and the U.S. Stock Market.

However, stock options appear to have motivated top managers to undertake riskier business strategies, including more debt, lower dividends and higher stock repurchases, according to the study. These riskier strategies have likely yielded higher levels of stock price volatility, which are not in the best interests of general shareholders.

Those results provide a sharp contrast with those companies with higher direct ownership of stock, which tend to have higher financial performance, lower volatility, higher dividends and more balanced stock repurchases.

“The increased use of stocks options has generally been healthy for both companies and the equity markets, but higher overhang levels also appear to be having a significant effect on stock price volatility,” according to Ira Kay, Ph.D., national director of compensation consulting at Watson Wyatt.

The study, “Stock Option Overhang – Shareholder Boon or Shareholder Burden?”, is based on publicly available data from 850 companies in the S&P 1500. A summary of the report is available online at: www.watsonwyatt.com/homepage/us/res.htm .

– Nevin Adams   editors@plansponsor.com