Stock Options

Posted by PITHOCRATES - April 29th, 2013

Economics 101

It takes a Lot of Time to Design, Develop and Bring to Market a Radical New Aircraft

The number one cost airlines have is fuel.  So anything that can reduce fuel consumption can cut an airline’s costs.  Aircraft manufacturers are aware of this.  And want to incorporate new fuel-saving technology into their aircraft.  Because that’s what airlines want.  And if you can give the airlines what they want they will buy your aircraft.  But sometimes new technology can be a little temperamental.  Everything doesn’t work as expected.  And sometimes problems that come up can take a long time to engineer through.  Like it did for the Boeing 787 Dream liner.

Boeing did everything they could think of to squeeze every last ounce of weight from the 787.  One thing they did is well known.  Thanks to a problem with it that caused the grounding of the entire 787 fleet.  The lithium-ion battery.  But that’s not the only weight-saving innovation of the 787.  They added Dual Electronic Flight Bags in the cockpit.  So pilots don’t have to bring bulky and heavy books aboard.  They went from conventional pneumatic architecture to more-electric architecture.  Eliminating the engine bleed air system and associated pneumatic system components.  Reducing weight and improving efficiency.  Which reduced fuel consumption.  They used simple trailing edge flaps.  Not slotted flaps.  Letting them use smaller flap track fairings (those canoe-shaped things underneath the trailing edge of the wings that operated the flaps).  Reducing drag.  And fuel consumption.  They used bigger engines with higher bypass ratios (the amount of air pulled into the fan disk but NOT used for combustion).  Increasing engine efficiency.  Reducing fuel consumption.  The use of composite materials decreased weight.  And the use of one-piece barrel sections eliminated additional joints, fasteners and splice plates.  Reducing weight.  And fuel consumption.

These and other innovations result in a fuel savings of 20% over similarly sized aircraft.  This is huge.  Which is why airlines are ordering this airplane.  But such a radical change in aircraft design comes with a lot of risks.  As the problem with the lithium-ion battery has shown.  And it takes a lot of time to design, develop and bring to market a new aircraft.  Especially one that is radically different from other airplanes.  So the decision to put the aircraft company on this course was a very risky decision.  And one that took a lot of guts.  Because so many things can go wrong.  Leading to cost overruns.  Which can delay promised delivery dates.  And Boeing had their share of those bringing the 787 to market.  Which they have worked through.  Will it be worth it?  As long as airlines want to save on fuel costs, yes.  And no problems arise that they can’t overcome.

Stock Options get Risk-Averse and Cautious CEOs to be Bold and Take Risks

These are big decisions.  Decisions that lead to great successes.  Or great failures.  Some so bad that they can bankrupt a company.  Someone has to be responsible for these decisions.  That one person sitting at the top of the corporation.  The CEO.  It is the CEO who has the ultimate say on the direction of the corporation.  And with this one decision all the resources of the corporation are marshaled together to take the corporation in this new direction.  Incurring great costs that will be on the books for years.  Making it hard to change course until these great investments pay off.  If they pay off.

These are the things CEOs have to deal with.  Not just at Boeing.  But throughout corporate America.  CEOs have to make these singular decisions that can have consequences for years to come.  Where it may take years to see if that one decision actually pays off.  There are few CEOs in the labor force.  So few can imagine the stress these people work under.  And in that pool of CEOs there are only a few that have the Midas touch.   Who can consistently take great risks while making all the right decisions.  Board members desperately want these CEOs.  Offering very generous compensation packages to lure them in.  And to keep them once they have them.  This crème de la crème of CEOs may make the big bucks.  But in exchange for that fat paycheck they do something few others can.  They make shareholders rich.  And they love making these owners rich.  For they love the thrill of the job.  Relishing that high-stress environment.  Where every little decision has great consequences.  Thriving under the kind of pressure that would leave most others whimpering in their beds.  Curled up in the fetal position.  In a pool of their own tears.

But not every corporation can get one of the crème de la crème.  They may have a great CEO.  But one that suffers from a major CEO character flaw.  Being averse to taking big risks.  Who instead wants to be a little more conservative.  And a little more cautious.  Shareholders don’t like overly cautious CEOs.  Because the people getting rich are doing it by breaking away from the pack.  By doing something different.  Abandoning convention.  Trying something bold.  And new.  Bringing something brand new to market that no one knows anything about.  But once they learn about it they can’t live without it.  This is what shareholders want.  Not cautious and conservative.  So to light a fire under these CEOs they came up with a new way to compensate them.  To appeal to their greed.  By letting them get rich if they can make that next great thing that sends the stock price soaring.  And the key to their greed is the stock option.

Stock Options provide a Powerful Incentive to bring Great New Things to Market

The CEO that creates the next big thing everyone will want to buy will send sales revenue soaring.  And with great sales revenue comes great profits.  Increasing the value of the company.  Which, in turn, makes the stock price soar.  This is what shareholders want.  A soaring stock price.  So to encourage the CEO to give them what they want they tie the CEO’s interest to their interests.  By giving the CEO stock options.  Making the sky the limit.  For the more the CEO increases the stock price the greater the CEO’s compensation.  Thus encouraging the CEO to try something bold and new.

A stock option is a right to buy a share of stock at a fixed price in the future.  Say the current stock price is $70/share.  The board of directors gives the CEO the option to buy, say, 500,000 shares of stock at $80/share up until some date in the future.  Creating a strong incentive for the CEO to raise the stock price.  The greater the CEO raises the price above $80 the greater his or her compensation.   Let’s say the CEO was bold and took a great risk.  And it pays off.  Sending the stock price soaring to $110/share.  When the CEO exercises those options he or she will buy 500,000 shares of stock from the company at $80/share.  The company gets $40 million in new capital to help finance further growth.  And the CEO will sell those 500,000 shares at the current market price of $110/share.  Pocketing $15 million.  And the shareholders, of course, get what they want.  A higher stock price.  Everyone wins.

Now let’s say that nothing spectacular happens.  And the stock price only rises to $75/share.  Because it’s below the ‘strike price’ the CEO will let these options expire.  The CEO profits nothing from these options.  But doesn’t lose anything either.  But what happens when the stock price falls because of that bold, new direction?  Causing the corporation to lose value.  As well as the shareholders.  But the CEO?  Again, the CEO will let those options expire.  And will lose no money.  Which is one of the benefits of stock options.  It got those risk-averse and cautious CEOs to take those big risks that got shareholders rich.  As there is no downside risk for the CEO.  Which is both good and bad.  On the one hand it encourages risk taking.  But on the other it encourages risk-taking.  Some CEOs will take excessive risks as they have nothing to lose.  Some will even cook the books to boost the stock price so they can exercise those options.  So it’s not a perfect system.  But they do provide a powerful incentive to bring great new things to market.  Which is what shareholders want.  And will take great risks themselves to get it.

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Incentive and Competition

Posted by PITHOCRATES - December 19th, 2011

Economics 101

Prices set by the Free Market make Competitors Think and Innovate

Agriculture advances gave us food surpluses.  Food surpluses gave us a division of labor.  The division of labor gave us trade.  Money made that trade more efficient.  Religion and the Rule of Law allowed great gatherings of people to live and work together in urban settings.  Free trade let us maximize this economic output and elevated our standard of living.  Free labor sustained economic growth by increasing the number of people making economic exchanges.  Prices automated the process of assigning value and allocating scarce resources (that have alternative uses).  But that’s not all.  Prices also provide incentive and competition.

High prices signal high profits.  Or the potential for high profits.  Which encourages other people to enter the market to get their piece of these high profits.  People who think they can do a better job.  Make something better.  And sell it for less.  That’s right, to get rich they will sell it for less.  That’s key.  That’s how you gain market share.  The ultimate goal of all businesses.  Because with market share comes profit.  And often times this happens even with a price below that of the competition.

Prices set by the market allow this amazing phenomenon to happen.  It stimulates the creative juices.  It makes competitors think.  And innovate.  Providing incentive.  To improve on an existing idea.  Or replace an existing idea with a better idea.  All the while being guided by market prices.  Which tell them the current value a buyer places on a product or service.  And the final cost they have to remain below to bring their innovation to market.  If they do both they will gain market share.  By giving customers better value at a lower price.  And they will make themselves rich in the process.  The proverbial win-win of the free market.  The hallmark of capitalism.  Incentive and competition.

With Crony Capitalism Government Increases the Cost of Competition, Squelching any Incentive to Innovate

Free market prices are essential for free market capitalism.  If the market is not free to determine prices this amazing phenomenon will not occur.  Consumers will not get more value for less.  And business people and entrepreneurs will not take chances and create more value for less.  Because if there are outside forces influencing prices these forces also create uncertainty.  They throw unknowns into business calculations.  Things businesses have no power over.  Which makes them cautious.  And less prone to risk-taking.

We can see examples of this every time there is unrest in the Middle East.  Which tends to threaten the oil supply.  Everything in a modern economy uses energy.  Nothing comes to market without energy.  So anything that affects energy prices affects all prices.  Another example is government’s regulatory cost.  Such as Obamacare.  Which has caused great uncertainty.  And a lot of unknowns.  For entrepreneurs.  And business owners.  Who don’t know the ultimate regulatory compliance cost.  Freezing hiring.  And business expansion.  Extending the Great Recession.  Causing the economy to spit and sputter along.  Like an engine that just won’t restart.

Typically when government over regulates it’s to reward their friends and cronies.  Hence the term crony capitalism.  Which isn’t even capitalism.  Crony capitalism is about getting rich by who you know in government.  Not by creating more value for less.  The government fixes the game by keeping prices high for their cronies.  By enacting regulations that increase the cost of competition.  Squelching any incentive to innovate.  Leaving consumers stuck paying more for less value.

When Government Interfered with Market Prices they gave us the Great Depression and the Great Recession

Free market prices assign value.  Allocate scarce resources that have alternative uses.  Provide incentive to innovate.  Encourage competition.  Incentive and competition.  The hallmark of capitalism.  Which ultimately provides consumers with more value at lower prices.  And it does all of this automatically.  As long as government doesn’t interfere with this automatic pricing mechanism.

But government often does.  They interfere with this automatic pricing mechanism to reward friends and cronies far too often.  When they do the economy suffers.  And often goes into recession.  And when they really interfere, they cause Great Depressions.  And Great Recessions.

Government regulatory policy turned an ordinary recession into the Great Depression.  One of their greatest anti-business regulations being the Smoot–Hawley Tariff Act.  Which launched an all out trade war.  Killing the economy.  And government regulatory policy in the mortgage industry caused the Great Recession.    First by creating a housing bubble by forcing lenders to qualify the unqualified.  And then enabling this bad policy on a grand scale by having Fannie Mae and Freddie Mac buy the resulting bad subprime mortgages.  Which removed all risk from the lenders so they kept on approving bad subprime mortgages.

Say what you will about the Great Depression and the Great Recession.  But what you can’t say is that they were market failures.  Because they weren’t.  Both were government-made.  Because it was government that interfered with market prices.  Not the free market.  And the consumers paid the price for their crony capitalism.

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Out of Control State Spending – Greece, France, the U.K. and the U.S.A.

Posted by PITHOCRATES - December 15th, 2010

Greece Burning – Public Sector Pay and Pensions Bankrupting the Nation

Things got ugly in Greece during their 2010 financial crisis.  At least three died one day during rioting (see Greek financial crisis explained posted 5/6/2010 on The BBC).

Three people, including a pregnant woman, have been killed during riots in Athens.

And why were the Greeks rioting?

Many of the protesters are public service workers, whose salary comes from the tax payer…

They object to their government’s plan to get Greece’s economy back under control.

It includes a freeze on public sector pay, raising the tax on fuel, and cutting pensions.

And why did Greece find herself in a position to take these austerity measures?

For years, Greece has been spending money it doesn’t have.

The government there took advantage of the economic good-times to borrow money and spend it on pay-rises for public workers and projects such as the 2004 Olympics.

France Burning – Early Retirement Age Bankrupting the Nation

Things weren’t much prettier in France.  They, too, were facing out of control state spending.  So they, too, tried to cut their spending.  And it didn’t go over well with the people (see Proposed retirement age change prompts riots in France by The Associated Press posted 11/4/2010 on The Chicago Sun-Times).

Workers opposed to a higher retirement age blocked roads to airports around France on Wednesday, leaving passengers in Paris dragging suitcases on foot along an emergency breakdown lane.

Outside the capital, hooded youths smashed store windows amid clouds of tear gas.

Riot police in black body armor forced striking workers away from blocked fuel depots in western France, restoring gasoline to areas where pumps were dry after weeks of protests over the government proposal raising the age from 60 to 62.

And what was their greatest fear of these austerity cuts?

Many workers feel the change would be a first step in eroding France’s social benefits – which include long vacations, contracts that make it hard for employers to lay off workers and a state-subsidized health care system – in favor of “American-style capitalism.”

The United Kingdom Burning – Cheap College Tuition Bankrupting the Nation

Meanwhile, in the U.K., they’re having their own riots.  And the rioters attacked the Royal Family.  Fortunately for Prince Charles, his car took the brunt of the attack (see Prince Charles’s car kicked in tuition riot by The Associated Press posted 12/9/2010 on CBC News). 

“We can confirm that the royal highnesses’ car was attacked by protesters on their way to their engagement at the London Palladium this evening. The royal highnesses are unharmed,” a statement from Prince Charles’s press secretary said.

And why were the people rioting?  Much like in Greece and France, the U.K.’s generous social benefits are bankrupting the nation.

Cameron’s government describes the move as a painful necessity to deal with a record budget deficit and a sputtering economy. To balance its books, the U.K. passed a four-year package of spending cuts worth $129 billion, which will lead to the loss of hundreds of thousands of public sector jobs and cut or curtail hundreds of government programs.

The government proposed raising the maximum university tuition fees in England from $4,780 a year to $14,000. Students reacted with mass protests that have been marred by violence and have paralyzed some campuses.

Not Burning Yet – Social Security and Medicare Bankrupting the Nation

Social Security and Medicare are going broke.  And will.  It’s just a matter of time.  When they came into being, there was an expanding birth rate.  Actuaries counted on those birth rates to continue.  But they didn’t.  The baby boom generation had only about 3 children per family.  Whereas their parent’s generation often had 10 kids or more.

Social Security is like a Ponzi Scheme.  There are no retirement accounts.  Payroll taxes from workers today pay the retirees of today.  Think pyramid scheme.  As long as the base of the pyramid (those workers paying taxes) grows at a greater rate than the tip of the pyramid (those collecting benefits) the scheme works.  But with the reduction in birth rates and our aging population, the pyramid has inverted.  The tip of the pyramid is growing at a greater rate than the base is.  As the ‘size’ of the tip and the base approach each other, eventually one worker will support one retiree.  And if a retiree lives on, say, $30,000 a year, do the math.  In a two-income family, one income will support a retiree.  And nothing else.  And that just ain’t sustainable.  Ergo, Social Security will go broke.

Ditto for Medicare.

Obamacare – Tinder, Gasoline and a Match

All right, we’ve seen how out of control state spending has led to austerity measures throughout Europe.  And rioting.  We have two huge entitlement programs pushing our county down the same path.  Europe is cutting costs (even when cities are burning in the process).  And what do we do?  We double down.  We add a third entitlement behemoth that will make Social Security and Medicare look tiny in comparison.

Obamacare.  Affordable health care for everyone.  Because the government is going to force everyone to buy health insurance.  Because the more people who pay premiums, the lower each premium needs to be.  Think pyramid scheme.  You need more to pay in (the base) than collect benefits (the tip).  Because this ain’t insurance.  It’s the mother lode of welfare entitlements.  And it’s also something else.  Unconstitutional (see Opposition to Health Law Is Steeped in Tradition by David Leonhardt posted 12/14/2010 on The New York Times).

On Monday, a federal judge ruled part of the law to be unconstitutional, and the Supreme Court will probably need to settle the matter in the end.

But that doesn’t stop the Obamacare cheerleaders.

We’ve lived through a version of this story before, and not just with Medicare. Nearly every time this country has expanded its social safety net or tried to guarantee civil rights, passionate opposition has followed.

The opposition stems from the tension between two competing traditions in the American economy. One is the laissez-faire tradition that celebrates individuality and risk-taking. The other is the progressive tradition that says people have a right to a minimum standard of living — time off from work, education and the like.

Yes, the two competing traditions.  The individuality and risk-taking that has defined America until Woodrow Wilson and the Progressives came along.  And the entitlement mentality.  Also known as European Socialism.  Like they have, had, have in Greece, France and Great Britain.  And we’ve seen how that has worked.  But we don’t learn from the lessons of history, do we?

The federal income tax, a senator from New York said a century ago, might mean the end of “our distinctively American experiment of individual freedom.” Social Security was actually a plan “to Sovietize America,” a previous head of the Chamber of Commerce said in 1935. The minimum wage and mandated overtime pay were steps “in the direction of Communism, Bolshevism, fascism and Nazism,” the National Association of Manufacturers charged in 1938.

When my dad worked gross pay meant something.  Today it’s all about net pay.  What’s left after taxes.  Taxes have grown so great that a single wage earner has trouble raising a family.  Unlike those families back before the baby boom.  When a single wage earner could raise 10 kids.  So, yes, the federal income tax has greatly changed the American experiment in individual freedom.

Social Security has ‘Sovietize’ America.  Retirees live in fear of losing their state benefits.  And they know that it’s in their ‘best interest’ to support the state.  And they do.  At the voting booth.  Potato.  Tomato.  The only difference is that we don’t have gulags in Siberia here.  But we don’t need them.  Because the threat of cutting a retiree’s benefits scares them enough to toe the party line.

And now we want to add national health care to the mix.  Because every other rich country has jumped off that bridge.

It is clearly one of the least radical ways for the United States to end its status as the only rich country with millions and millions of uninsured.

There’s a reason why the U.S. does not pay for millions and millions of uninsured here.  Why?  See Greece, France and the U.K. above. 

Guaranteeing people a decent retirement and decent health care does more than smooth out the rough edges of capitalism. Those guarantees give people the freedom to take risks. If you know that professional failure won’t leave you penniless and won’t prevent your child from receiving needed medical care, you can leave the comfort of a large corporation and take a chance on your own idea. You can take a shot at becoming the next great American entrepreneur.

With every previous major expansion of the safety net, history has had a chance to prove the naysayers wrong. It may yet in the case of universal health coverage. But the decision now seems to rest with the nine members of the Supreme Court.

Again, see Greece, France and the U.K. above.  As nice and compassionate as it sounds, it just doesn’t work.  European Socialism.  If it did, it would have worked in Greece, France and the U.K.  But it didn’t.  And that should scare the hell out of us here.  Because we’re heading down the same road.

And history may just prove the naysayers were right.

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