As an investor, the two words that you should dread the most in a financial statement are “adjusted earnings”, as companies take accounting earnings and tweak them for sundry items.
In the process, they almost always turn big losses into smaller ones, and losses into profits. One adjustment that is consistently made to get to adjusted earnings, or ebitda, is the adding back of stock-based employee compensation, with the rationale that it is either a non-recurring operating expense or, more frequently, that it is a non-cash expense. The adjustment has its biggest impact at young, high-growth companies, which are among the most prolific users of equity compensation.
Uber, for instance, reported $172m in stock-based compensation expenses in 2018, but the usage of employee options and restricted stock is widespread, with the cost tallying to $1.1bn at Amazon and $1.7bn at Apple in the most recent year. Lest you think that this is a phenomenon unique to technology companies, Wells Fargo and JPMorgan Chase had $2.4bn and $1.9bn in equity-based compensation respectively, during the most recent 12 months. In short, as an investor, you can run but you cannot hide from this phenomenon.
There was a leap in the usage of stock options by publicly traded companies in the 1990s. This was driven by flawed accounting practices, bad legislation and the public listings of young, money-losing firms. In particular, accounting rules allowed companies to give options to employees and to show no cost, at the time of the grant. Not surprisingly, companies treated options as free currency and gave away large slices of ownership to employees.
It is ironic that just as accountants have come to their senses and started treating stock-based compensation as operating expenses, that companies and analysts have nullified the impact by adding these expenses back to get to adjusted earnings. It is also telling that as the accounting treatment of stock options has become more rational, companies have not reduced stock-based compensation but have shifted to restricted stock as their preferred mode.
To the question of whether stock-based compensation is an operating expense, I offer you Warren Buffett: “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses should not go into the calculation of earnings, where in the world should they go?”
Stock-based compensation is an expense that should be recognised when granted and as employees have to continue to be compensated, it is an ongoing operating expense. To those who argue that it is non-cash, note that unlike depreciation, which is truly non-cash, stock-based compensation is closer to in-kind compensation.
Assume that you own a business that has an overall value of $100m and generates $10m in annual income, and that you hire me as your manager. Assume also that my compensation is $1m and that rather than pay me with cash, you give me 1 per cent of the business as compensation. While you may maintain the fiction that this is a non-cash expense and that your income is still $10m, you are now entitled to only 99 per cent of that income in perpetuity. In effect, your share of the business is worth less and it will get even smaller over time, if you continue to pay me with equity.
But if you are a common stockholder in any company that grants options or restricted stock to its employees, then you are in exactly the same position.
So, what should investors do? If you expect the company to continue paying its employees with options or restricted stock, you should forecast lower earnings and cash flows than for an otherwise similar company that does not follow the same practice. And, if the company has used options in the past that are still “live”, the value of these options has to be netted out of the value of equity to arrive at the value of common shares.
If you use multiples and peer group comparisons, you are still affected by stock-based compensation’s consequences. Thus, if you are comparing price/earnings ratios across technology firms and you use fully diluted shares to compute per-share numbers, you will tend to find that companies that have more options outstanding will look cheaper, because they will trade at lower multiples of earnings. With primary earnings per share, you will come to the opposite conclusion. In fact, as stock-based compensation proliferates, you should view per-share numbers reported by analysts or data services with scepticism and follow the adage of “trust but verify”.
The bottom line is that if a company chooses to pay an employee with options or restricted stock, that action will affect the value of your share of equity in the company, no matter how many contingencies are added to these claims.
There are good reasons for companies to use stock instead of cash to compensate employees, including being cash-poor and aligning incentives. But there is no reason for investors to give stock-based compensation a free pass, when computing earnings or cash flows.
Aswath Damodaran is a professor of finance at the Stern School of Business at New York University