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A good sell-side research report contains a detailed analysis of a company's competitive advantages and provides information on management's expertise and how the company's operating and stock valuation compares to a peer group and its industry. The typical report also contains an earnings model and clearly states the assumptions that are used to create the forecast. Writing this type of report is a time consuming process. Information is obtained by reading the company's filings for the Securities & Exchange Commission, meeting with its management and, if possible, talking with its suppliers and customers. It also entails analyzing (using the same process) the company's publicly-traded peers for the purpose of better understanding differences in operating results and stock valuations. This approach is called fundamental analysis because it focuses on the company's fundamentals. This is a rigorous and time-consuming process that limits a typical sell-side analyst specializing in two or three industries and covering about 10-15 companies, depending on the number of sectors he or she follows.The challenge facing the brokerages is that it's extremely expensive to create all this research. Brokerages must recover the costs of paying sell-side analysts from somewhere, but deregulation has significantly reduced the ability to make a profit at anything except investment banking deals. The main result of these "forces" is that research departments cannot research any companies that do not have a potential investment bank deal of about $50 million or more. This leaves thousands of great companies without research. Couple this with the fact that research departments drop coverage rather than issue "sell" reports, and you'll get the perception that analysts only issue "buy" recommendations.
You can read the first part of this series here.Why Options Are Used As CompensationUsing options instead of cash to pay employees is an attempt to "better align" the interests of the managers with those of the shareholders. Using options is supposed to prevent management from maximizing short-term gains at the expense of the long-term survival of the company. For example, if the executive bonus program consists solely of rewarding management for maximizing near-term profit goals, there is no incentive for management to invest in the research & development (R&D) or capital expenditures required to keep the company competitive over the long term. Managements are tempted to postpone these costs to help them make their quarterly profit targets. Without the necessary investment in R&D and capital maintenance, a corporation can eventually lose its competitive advantages and become a money-loser. As a result, managers still receive their bonus pay even though the company's stock is falling. Clearly, this type of bonus program is not in the best interest of the shareholders who invested in the company for long-term capital appreciation. Using options instead of cash is supposed to incite the executives to work so the company achieves long-term earnings growth, which should, in turn, maximize the value of their own stock options.
Everything changed in the mid-1990s. The use of options exploded as all types of companies began using them as a way to finance growth. The dotcoms were the most blatant users (abusers?) - they used options to pay employees, suppliers and landlords. Dotcom workers sold their souls for options as they worked slave hours with the expectation of making their fortunes when their employer became a publicly-traded company. Option use spread to non-tech companies because they had to use options in order to hire the talent they wanted. Eventually, options became a required part of a worker's compensation package. By the end of the 1990s, it seemed everyone had options. But the debate remained academic as long as everyone was making money. The complicated valuation models kept the business media at bay. Then everything changed, again.
You can read the first part of this series here.Why Options Are Used As CompensationUsing options instead of cash to pay employees is an attempt to "better align" the interests of the managers with those of the shareholders. Using options is supposed to prevent management from maximizing short-term gains at the expense of the long-term survival of the company. For example, if the executive bonus program consists solely of rewarding management for maximizing near-term profit goals, there is no incentive for management to invest in the research & development (R&D) or capital expenditures required to keep the company competitive over the long term. Managements are tempted to postpone these costs to help them make their quarterly profit targets. Without the necessary investment in R&D and capital maintenance, a corporation can eventually lose its competitive advantages and become a money-loser. As a result, managers still receive their bonus pay even though the company's stock is falling. Clearly, this type of bonus program is not in the best interest of the shareholders who invested in the company for long-term capital appreciation. Using options instead of cash is supposed to incite the executives to work so the company achieves long-term earnings growth, which should, in turn, maximize the value of their own stock options.
Everything changed in the mid-1990s. The use of options exploded as all types of companies began using them as a way to finance growth. The dotcoms were the most blatant users (abusers?) - they used options to pay employees, suppliers and landlords. Dotcom workers sold their souls for options as they worked slave hours with the expectation of making their fortunes when their employer became a publicly-traded company. Option use spread to non-tech companies because they had to use options in order to hire the talent they wanted. Eventually, options became a required part of a worker's compensation package. By the end of the 1990s, it seemed everyone had options. But the debate remained academic as long as everyone was making money. The complicated valuation models kept the business media at bay. Then everything changed, again.
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