For the period between 1999 and 2000, application of the fair value method would have reduced earnings growth among S & P 500 companies by an average of 7.0 percent. Because of the poor absolute earnings situation in 2001, which was caused by difficult economic conditions, the influence of employee options increased significantly. Earnings would have been 21 percent lower than actually shown.

The picture for 2002 is rather less dramatic because we are assuming that earnings will recover across the whole of the equities market. The influence of employee options will fall again as a consequence, resulting in 10 percent lower profits. Even if current earnings estimates were cut by 10 percent, the equity market would still not be overvalued according to the risk premium model. This model is one of the most commonly used tools for valuing equity markets. In our view, therefore, a large part of this earnings adjustment is already priced into the index for the market as a whole. We are less sure that this is the case for individual sectors of some stocks.

Marked deviations appear at the sector level between reported and adjusted profits. What is less surprising is that the technology companies, the main lobbyists for the intrinsic value method, suffer the greatest adjustments. During the boom years of 1999 and 2000, the negative influence on profits in the sector was around 20 percent; in 2001 this rose to almost 40 percent. The impact may well be even greater this year, since absolute earnings estimates are at a very low level: higher staff costs thus have a disproportionately large influence on operating and net profits. We estimate a substantial reduction of 70 percent.

However, the importance of this should not be overemphasized since earnings estimates for 2003 trending significantly upward, which means that the influence of stock options will decrease once again. The telecoms sector is much less affected, though it still comes in second place with a reduction for 2002 of 12 percent. Of the large sectors, the financial and health industries have below average earnings reductions, with an expected decrease in 2002 of 5 percent and 7 percent respectively.

The picture is very mixed not just at the sector level, but also at the individual stock level. In certain circumstances, equities that had previously been cheaply valued based on relative valuation indicators such as the P/E ratio can suddenly appear very expensive.

Let us take two prominent examples from the technology industry: Cisco and IBM. Based on consensus estimates Cisco can expect earnings per share (EPS) of $0.36 in 2002; but if we calculate profits using the fair value method, we arrive at an EPS of only $0.12. Based on the share price of Aug. 12, this gives a P/E ratio for 2002 of 36.1x, or adjusted of 108.3x. The situation is less dramatic at IBM. Its 2002 EPS is estimated at $4.03, or $3.37 on an adjusted basis. IBM’s P/E ratio for 2002 would thus be either 17.4x or 20.8x. We can see then, that Cisco becomes much more expensive compared with IBM.

We believe that more and more investors will focus on adjusted earnings when making their investment decisions, which means that companies that need to adjust less should do better than companies that otherwise experience an identical business performance by which have to undertake greater adjustments.

As always, not all that glitters is gold. Even if the fair value method gives a closer approximation to the real situation, it cannot provide a completely accurate reflection. For example, volatile equity markets or the level of capital market interest rates can dramatically change the valuation of options. If interest rates are low and the markets are very volatile, the costs will be too high in the income statement. The picture becomes even more dramatic if options are not exercised owing to heavy falls in the share price. Firstly, the costs are never actually incurred in reality; and secondly, there is no additional dilution when calculating earnings per share.

Finally, we cannot afford to underestimate the disadvantage of the fair value method to the economy as whole. Young businesses, perhaps involved with very forward-looking technologies, may not have the financial resources required to pay market salaries, so they rely heavily on employee options and employee share schemes to attract staff.

In future, such companies will show greater losses and may thus find it harder to secure liquidity. Some innovative, job-creating firms may thus find themselves sidelined.

(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to its accuracy.)

(This is Part II of a two-part series)