Equity Research

26 September 2002Americas/United States

StrategyInvestment Strategy

Unfounded FearsExpensing ESO's and Stock Prices

Price Impact Following ESO Voluntary Expensing

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Price Impact Following ESO Voluntary Expensing

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Markets tend to be self-correcting. We are seeing many companies alter theirexecutive compensation practices. This is a healthy trend.

We believe that the FASB will mandate expensing employee stock options by2004. Over 100 companies have announced their intention to voluntarilyexpenses options, although most large options users are conspicuouslyabsent from the list.

Market efficiency holds that stock prices reflect available public information.The details of employee stock option programs are already public. So weshould not expect to see stock price changes when companies convert theinformation from the footnotes to the income statement.

We analyzed the stock price impact of those companies that have announcedthat they will voluntarily expense options. Our analysis shows that the meanand median change in stock price was very close to zero for the one-, two-and three-day period subsequent to the announcement. This suggests thatmarkets already reflect the impact of options in value.

Investors should assume that CSFB is seeking or will seek investment banking or other business from the coveredcompanies.

research team

Michael Mauboussin212 325 3108michael.mauboussin@csfb.com

Kristen Bartholdson212 325 2788Kristen.bartholdson@csfb.com

Unfounded Fears 26 September 2002

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The Market Gets ItAn important feature of free markets is that they tend to be self-correcting. Some timemay pass before the pendulum swings, but eventually markets help wring out excesses.Executive compensation has been one area of excess in corporate America over thepast decade, especially in the form of employee stock options (ESOs). Companies arefeeling pressure to reel in the extravagances of the late 1990s.

One factor modifying behavior is the near-certainty that the Financial AccountingStandards Board (FASB) will require companies to reflect an expense for ESOs on theirincome statements by 2004. While the economics of ESOs are unchanged, managersare already revisiting their options programsboth the magnitude and administrationin anticipation of more transparent disclosure. This is a healthy trend.

In addition, over 100 companies have announced their intention to voluntarily expenseESOs on their income statement. This group includes a number of high profile U.S.companies like GE, Citigroup and Coca-Cola. Unfortunately, very few options-ladentechnology firms have chosen to expense. One notable exception is Amazon.com.

One of the reasons executives (especially technology company executives) have balkedat voluntarily expensing options is the fear that lower reported earnings would lead tolower shareholder value. This view is based on the idea that investors simplisticallyplace a multiple on reported earningsso lower earnings at the same multiple yields alower stock price. A number of companies and other interested parties, includingprominent venture capitalists, have used this argument as their prime objection toexpensing.

From an academic perspective, this argument holds no water. ESOs represent aninteresting case in market efficiency precisely because accounting rules alreadymandate that companies disclose a substantial amount of information about theiroptions programs. Market efficiency holds that share prices reflect publicly availableinformation. So shifting the information about options from the footnotes to the incomestatement should not have an impact on shareholder value in an efficient market.

We tested this idea by looking at the change in stock price versus the market for thecompanies that announced their intention to expense options. In these cases, reportedearnings per share go down to reflect the previously unrecognized options expense. Ouranalysis shows that the mean and median change in stock price was very close to zerofor the one-, two- and three-day period subsequent to the announcement. (See Exhibit1.) In other words, this analysis shows that the market already reflects the impact ofoptions in valuation. (See Appendix A for the full listing.)

Exhibit 1: Price Impact Following ESO Voluntary Expensing

Source: Company data, CSFB estimates.

One-Day Two-Day Three-DayAverage 0.1% 0.5% 0.2%Median 0.1% 0.2% 0.5%

Standard Deviation 4.0% 5.1% 5.3%

Unfounded Fears 26 September 2002

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We should note that isolating the impact of expensing options is often difficult to dobecause companies often announce their intention to expense options coincidently withother information, including earnings releases and changes in corporate governance.But in the cases where the options announcement appears without other developments,the stock price performance is not significantly different than zero.

While the debate continues about how to best reflect options in financial statements, theevidence suggests that markets are already accurately reflecting the economics on ESOprograms. The debate, then, should shift from how companies should treat options intheir financial statements to more substantial corporate governance issues. Theseissues include the magnitude of annual grants, whether or not options provide theappropriate incentives, and which employees should receive options.

Unfounded Fears 26 September 2002

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Appendix AExhibit 2: Cumulative Abnormal Return

Cummulative AbnormalCompany Name Ticker Day Before Announcement 1 day chg 2 day chg 3 day chgAIG AIG 8/10/02 -1.6% -4.2% -5.8%Allstate Insurance ALL 8/12/02 * -0.1% -2.0% -2.7%Amazon AMZN 7/22/02 * -2.0% -9.6% -16.1%AMB Property AMB 7/7/02 * 1.1% 0.1% 3.4%Ambac ABK 7/16/02 * -5.5% -6.0% -0.8%American Express AXP 8/12/02 * 0.3% 0.8% 2.6%Bank of America BAC 8/12/02 0.6% -0.9% -1.5%Bank of New York BK 8/12/02 -1.0% -1.1% -1.4%Bank One ONE 7/15/02 * 6.3% 4.8% 2.5%BayCorp Holdings MWH 8/13/02 * -3.8% -4.0% -3.7%Calpine CPN 8/26/02 -7.5% -1.0% -7.6%Camden National CAC 8/26/02 -1.0% -0.3% 3.2%Cendant CD 8/27/02 1.2% 0.2% -1.2%Centex CTX 9/11/02 -1.6% -0.1% -0.1%Charter Communications CHTR 8/5/02 * 8.1% -8.5% 0.7%Chubb CB 8/12/02 1.0% 1.3% -1.8%Cinergy CIN 7/23/02 * 2.8% 8.4% 5.1%Citigroup C 8/6/02 * 1.7% 6.2% 7.2%Coca Cola KO 7/13/02 2.2% 0.9% -0.4%Comerica CMA 8/5/02 -0.6% -2.5% 0.0%Computer Associates CA 7/28/02 2.0% 14.5% 8.4%Contango Oil & Gas MCF 8/4/02 * 5.2% 3.8% 1.8%Cooper Industries CBE 8/5/02 * 1.1% 4.4% 0.6%Costco COST 8/13/02 1.5% 5.9% 2.8%Dole Food DOL 7/17/02 * 1.7% 3.5% 7.1%Dow Chemical DOW 8/25/02 * 1.3% 3.6% 2.8%Duke Realty DRE 7/30/02 * -0.4% 1.5% 1.8%Emerson Electric EMR 8/5/02 * -1.5% -0.4% -0.2%Fannie Mae FNM 7/22/02 2.8% 1.6% 1.1%FBL Financial FFG 8/29/02 -1.6% 0.5% 1.2%FleetBoston Financial FBF 8/13/02 * -3.3% -5.5% -3.8%Fleming Companies FLM 8/17/02 -0.9% -0.6% 0.4%Freddie Mac FRE 7/22/02 4.1% 4.3% 3.2%Gabelli Asset Management GBL 7/25/02 -2.8% -9.5% -9.9%General Electric GE 7/31/02 * 0.5% -3.2% -3.7%General Motors GM 8/5/02 * -0.4% 0.0% -2.6%Gildan Activewear GIL 8/7/02 * 2.4% 5.9% 4.1%Goldman Sachs Group GS 8/11/02 0.4% 1.8% 2.8%Grey Global Group GREY 8/13/02 * -5.1% -4.2% -5.8%H&R Block HRB 9/10/02 -0.8% 2.3% 1.3%Handleman HDL 9/9/02 -2.5% -3.9% 3.3%Hartford Financial Services Group Inc. HIG 8/23/02 1.2% -0.7% -1.0%Home Depot HD 8/22/02 * 1.3% 1.7% 0.5%Home Properties of NY HME 8/7/02 * -2.0% -4.9% -1.1%Household International HI 7/16/02 * -8.6% -5.8% -5.8%Iomega IOM 7/23/02 -2.1% -0.4% 3.8%iStar Financial SFI 7/24/02 * 6.2% 7.7% 4.1%Jones Apparel JNY 7/30/02 * -2.4% -1.0% -2.1%JP Morgan Chase JPM 8/11/02 * -2.8% -4.7% -5.8%Kellwood KWD 8/28/02 * -1.9% 3.2% 3.0%Lee Enterprises LEE 7/21/02 * 4.5% 7.7% 4.9%Lifepoint Hospitals LPNT 8/7/02 -0.2% -5.1% -9.4%Lincoln National LNC 8/12/02 -1.4% -1.1% -1.1%Lowe's Cos. LOW 8/18/02 * 9.1% 13.2% 14.2%M&T Bank Corp. MTB 9/19/02 * -0.1% 2.6% 2.7%MacDermid MRD 7/25/02 * 1.5% 4.7% 1.6%Marathon Oil MRO 8/5/02 1.2% 2.7% 2.5%May Department Stores MAY 8/16/02 * -0.1% -0.6% -0.4%Maz Re Capital MXRE 9/8/02 -0.6% -1.1% 0.1%MBIA MBI 7/29/02 3.0% 1.6% 3.7%Mellon Financial MEL 8/13/02 0.3% 0.7% -1.3%Merrill Lynch MER 8/12/02 * -0.1% 0.0% 1.8%MetLife MET 8/11/02 * -0.7% -0.8% -2.2%Morgan Stanley MWD 8/12/02 0.5% 3.3% 2.6%Neuberger Berman NEU 7/24/02 * -0.5% 1.6% 5.5%

Unfounded Fears 26 September 2002

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Exhibit 1 continuedCummulative Abnormal

Company Name Ticker Day Before Announcement 1 day chg 2 day chg 3 day chgPapa John's Pizza PZZA 7/30/02 * 2.4% 4.5% 3.1%Plum Creek Timber PCL 8/1/02 1.0% 3.6% 1.5%Pogo Producing PPP 8/7/02 2.0% 6.9% 9.2%Predictive Systems Inc. PRDS 9/18/02 * -16.4% -5.2% -2.7%Premcor PCO 8/5/02 * -9.4% -9.3% -9.9%PriceSmart PSMT 8/1/02 1.6% 5.6% 3.5%Principal Financial PFG 8/6/02 * 1.9% 3.9% 8.1%Procter & Gamble PG 8/4/02 * 0.8% -1.8% -2.5%Prudential Financial PRU 8/12/02 -0.4% -0.2% -2.0%PS Business Parks PSB 9/8/02 * -1.4% -1.8% -1.9%Quest Diagnostics DGX 7/23/02 * 6.2% -8.6% -12.1%Raven Industries RAVN 8/19/02 * 2.5% 3.9% 3.0%Realty Income O 7/25/02 * 5.9% 1.8% 1.0%Saks Inc SKS 8/20/02 * 14.6% 20.3% 14.4%Schlotzsky's BUNZ 8/13/02 * -9.6% -11.5% -19.4%Scotts Co SMG 7/25/02 * 3.1% 2.0% 0.3%Servicemaster SVM 7/29/02 * -1.1% 1.6% -0.2%Smithfield Foods SFD 8/21/02 * -5.0% 0.2% 0.3%Sovereign Bancorp SOV 7/18/02 * 6.4% 9.4% 5.7%State Street STT 8/12/02 * -1.5% -1.1% 0.0%Steelcase SCS 9/23/02 * -8.4% -11.7% -11.7%Sun Life Financial Services of Canada SLC 7/30/02 * -0.1% 0.6% 3.0%Sunoco SUN 9/10/02 0.0% -1.4% -1.7%SunTrust Banks STI 8/12/02 0.1% -0.6% -1.0%Tarragon Realty Inv TARR 8/4/02 3.4% -0.9% -1.4%TB Woods TBWC 7/30/02 * 0.9% 1.2% 4.2%Temple Inland TIN 8/4/02 0.8% 1.3% 0.3%Tupperware TUP 8/5/02 * -0.6% -1.7% -3.6%UPS UPS 8/18/02 * -1.2% -1.2% -2.2%USA Interactive USAI 7/23/02 * 7.6% 4.9% 7.7%Valley National Bancorp VLY 7/16/02 * 0.2% 0.4% 4.4%Vornado Realty Trust VNO 8/6/02 -1.1% -7.2% -8.6%Wachovia WB 7/17/02 * -3.6% -1.9% 1.1%Wal Mart WMT 8/13/02 * 4.0% 7.1% 5.4%Washington Post WPO 7/14/02 0.2% 0.7% 1.7%Webster Financial WBST 7/23/02 * -1.2% 4.2% 4.7%World Fuel Services INT 7/31/02 * -0.8% -0.6% 2.4%

1 Day 2 Day 3 DayAverage 0.1% 0.5% 0.2%Median 0.1% 0.2% 0.5%

Standard Deviation 4.0% 5.1% 5.3%

Source: FactSet.

* Denotes other significant company news

Unfounded Fears092602.doc

AMSTERDAM............. 31 20 5754 890ATLANTA ................... 1 404 897 2800BALTIMORE............... 1 410 659 8800BANGKOK ...................... 62 614 6000BEIJING.................... 86 10 6410 6611BOSTON..................... 1 617 556 5500BUDAPEST .................. 36 1 202 2188BUENOS AIRES....... 54 11 4394 3100CHICAGO ................... 1 312 750 3000FRANKFURT................. 49 69 75 38 0HOUSTON .................. 1 713 890 6700HONG KONG .............. 852 2101 6000JOHANNESBURG 27 11 343 2200

KUALA LUMPUR........ 603 2143 0366LONDON .................. 44 20 7888 8888MADRID .................... 34 91 423 16 00MELBOURNE............. 61 3 9280 1888MEXICO CITY ............. 52 5 283 89 00MILAN ............................ 39 02 7702 1MOSCOW................... 7 501 967 8200MUMBAI ..................... 91 22 230 6333NEW YORK................ 1 212 325 2000PALO ALTO............... 1 650 614 5000PARIS....................... 33 1 53 75 85 00PHILADELPHIA ......... 1 215 851 1000

SAN FRANCISCO.......1 415 836 7600SO PAULO .............55 11 3841 6000SEOUL ........................82 2 3707 3700SHANGHAI................86 21 6881 8418SINGAPORE ..................65 6212 2000SYDNEY......................61 2 8205 4433TAIPEI .......................886 2 2715 6388TOKYO........................81 3 5404 9000TORONTO...................1 416 352 4500WARSAW....................48 22 695 0050WASHINGTON............1 202 354 2600ZURICH ........................41 1 333 55 55

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The Market Gets It Appendix A