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give them the right (but not the obligation) to buy shares in the future at a discounted price. That conversion of options to shares is called “exercising” the options. The employees can then sell the shares at the current market price and pocket the difference as profit. Because hundreds of millions of options may be exercised in a given year, the company must increase its supply of shares outstanding. Then, however, the company’s total net income would be spread across a much greater number of shares, reducing its earnings per share. Therefore, the company typically feels compelled to buy back other shares to cancel out the stock issued to the option holders. In 1998, 63.5% of chief financial officers admitted that counteracting the dilution from options was a major reason for repurchasing shares (see CFO Forum, “The Buyback Track,” Institutional Investor, July, 1998).

18 One of the main factors driving this change was the U.S. Securities and Exchange Commission’s decision, in 1982, to relax its previous restrictions on share repurchases. See Gustavo Grullon and Roni Michaely, “Dividends, Share Repurchases, and the Substitution Hypothesis,” The Journal of Finance, vol. 57, no. 4, August, 2002, pp. 1649–1684.

19 Throughout his writings, Graham insists that corporate managements have a duty not just to make sure their stock is not undervalued, but also to make sure it never gets overvalued. As he put it in Security Analysis (1934 ed., p. 515), “the responsibility of managements to act in the interest of their shareholders includes the obligation to prevent—in so far as they are able—the establishment of either absurdly high or unduly low prices for their securities.” Thus, enhancing shareholder value doesn’t just mean making sure that the stock price does not go too low; it also means ensuring that the stock price does not go up to unjustifiable levels. If only the executives of Internet companies had heeded Graham’s wisdom back in 1999!

20 Incredibly, although options are considered a compensation expense on a company’s tax returns, they are not counted as an expense on the income statement in financial reports to shareholders. Investors can only hope that accounting reforms will change this ludicrous practice.

21 See George W. Fenn and Nellie Liang, “Corporate Payout Policy and Managerial Stock Incentives,” Journal of Financial Economics, vol. 60, no. 1, April, 2001, pp. 45–72. Dividends make stocks less volatile by providing a stream of current income that cushions shareholders against fluctuations in market value. Several researchers have found that the average profitability of companies with stock-buyback programs (but no cash dividends) is at least twice as volatile as that of companies that pay dividends. Those more variable earnings will, in general, lead to bouncier share prices, making the managers’ stock options more valuable—by creating more opportunities when share prices will be temporarily high. Today, about two-thirds of executive compensation comes in the form of options and other noncash awards; thirty years ago, at least two-thirds of compensation came as cash.

22 Apple Computer Inc. proxy statement for April 2001 annual meeting, p. 8 (available at www.sec.gov). Jobs’ option grant and share ownership are adjusted for a two-for-one share split.

* By the late 1990s, this advice—which can be appropriate for a foundation or endowment with an infinitely long investment horizon—had spread to individual investors, whose life spans are finite. In the 1994 edition of his influential book, Stocks for the Long Run, finance professor Jeremy Siegel of the Wharton School recommended that “risk-taking” investors should buy on margin, borrowing more than a third of their net worth to sink 135% of their assets into stocks. Even government officials got in on the act: In February 1999, the Honorable Richard Dixon, state treasurer of Maryland, told the audience at an investment conference: “It doesn’t make any sense for anyone to have any money in a bond fund.”

* This is one of Graham’s rare misjudgments. In 1973,