Share-based Compensation: Impact On Tech Stock P/E Ratios

This Barron's article covers how some tech companies believe that ignoring share-based compensation expense makes sense.

Believing this, they naturally encourage investors and analysts to do the same.

As it turns out, many sell side analysts generally do agree to ignore stock expense for certain tech companies.

Barron's: Beware the Hidden Costs in Tech

Keep in mind that, at least for some of these tech companies, the stock expense is far from insignificant relative to earnings overall.

Below I've listed just some of the examples provided in the article of tech companies who encourage investors and analysts to view earnings excluding stock-based compensation. The article provides even more examples
(Clearly there are even more. Cisco (CSCO) and eBay (EBAY) come to mind. Both companies place an emphasis on Non-GAAP results that exclude stock-based compensation but happen to not be highlighted in the article.)

The first number -- 2013 P/E Excluding Stock Expense -- is what the P/E ratio looks like ignoring stock-based compensation.

The second number -- 2013 P/E Including All Expenses -- is what the P/E is including this very real expense.
                                     
Amazon.com (AMZN)
2013 P/E Excluding Stock Expense: 88.9x
2013 P/E Including All Expenses: 200.6x

Google (GOOG)
2013 P/E Excluding Stock Expense: 18.9x
2013 P/E Including All Expenses: 21.9x

Facebook (FB)
2013 P/E Excluding Stock Expense: 43.1x
2013 P/E Including All Expenses: 66.4x

LinkedIn (LNKD)
2013 P/E Excluding Stock Expense: 116.8x
2013 P/E Including All Expenses: 806.4x

Salesforce.com (CRM)
2013 P/E Excluding Stock Expense: 87.3x
2013 P/E Including All Expenses: NM*
Sources: Thomson Reuters; Bloomberg

For certain tech stocks (though not all, of course), the consensus estimates by some analysts are based upon the more optimistic numbers that ignore stock-based costs.
(I personally don't consider analyst estimates in my investment decision-making but, for those who might, the prevalence of this practice should be at least mildly interesting.)

Whether the above are great companies or not, their valuation can't be judged meaningfully when these costs are excluded.

It's worth mentioning (as the article does) that some other tech businesses**, including the likes of Microsoft (MSFT), Apple (AAPL), and Intel (INTC), all report and emphasize their GAAP results.

An approach that includes all costs.***

The article points out that this practice of ignoring stock-based compensation is really not found outside of tech and biotech.

Now, there are situations -- to be judged on a case-by-case basis -- where it makes sense to exclude certain noncash expenses. One example provided in the article is the amortization of intangibles. From the article:

It's easier to argue that those noncash expenses should be excluded from earnings—Warren Buffett advocates such an approach—but amortization of intangibles is relatively small compared with stock compensation.

One seemingly favorable trend is that some tech companies have moved away from compensating with the more difficult to value stock options to compensating with the easier to value stock-based compensation in the form of restricted stock.

For many reasons, this seems a very good thing but one has to at least attempt to estimate the stock-based costs whether it is difficult to value or not. More from the article:

"It's hard to argue that stock-based compensation isn't an expense," says Robert Willens, a New York–based tax expert. 

He also added:

"Because the medium of payment is stock doesn't make it less of an expense." 

The tech industry now advances various arguments for excluding restricted stock as an expense, with the chief being that the stock is "noncash." That's dubious since the stock clearly has value and is highly desired by employees for that reason.

For reasons that seem debatable at best, some tech investors and even analysts choose to exclude stock-based costs:

Tech investors and analysts essentially agree to exclude the stock expense and value companies accordingly. As one major tech investor told Barron's, "The sell side totally ignores the topic."

The article also points out:

- Companies will buy back stock to prevent increases to shares outstanding resulting from things like exercised employee options.

- The cost of those buybacks does not come out of free cash flow.

What's the net effect?

...a phony boost in free cash flow relative to the free cash flow of companies that pay their employees in cash. 

So, if the stock expense is generally ignored, guess what's likely to happen?

Well, it seems likely to encourage more use of stock-based compensation.

Those who choose to ignore stock-based compensation for certain companies but not others are essentially agreeing to compare economic apples to oranges. When a company has to buy back stock to just keep the share count from growing, those are funds that could be used for the direct benefit of shareholders in other ways.

So it's a real cost.

- That cash could be used for reducing share count instead of merely offsetting shares issued when stock options are exercised.

"Sometimes...companies say they are repurchasing shares to offset the shares issued when stock options granted at much lower prices are exercised. This 'buy high, sell low' strategy is one many unfortunate investors have employed -- but never intentionally! Managements, however, seem to follow this perverse activity very cheerfully." - From the 1999 Berkshire Hathaway (BRKaShareholder Letter

- That cash could be used for paying dividends.

- It could also be potentially put to many other high return uses.

Now, if a company needs to use stock to get the best employees it may be very wise to do so.

No problem.

Just count it as the real -- if sometimes difficult to estimate -- expense that it is.

It's worth pointing out that it's not as if the GAAP numbers are always a terrific indication of actual business economics.

Accounting is a very useful things but has its own severe limitations. Some of it likely at least somewhat fixable, while other aspects of its weaknesses may be more inherent. There are many ways that the accounting can also lead investors astray when it comes to valuing a business.

"...although accounting is the starting place, it's o­nly a crude approximation. And it's not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn't make it anything you really know." - Charlie Munger in a speech at USC Business School in 1994

Accounting numbers are, at best, a useful approximation of what is happening in a business. It's only a starting point when it comes to understanding long run economic prospects and intrinsic business value.

Still, in this case, it is a far better place to start than ignoring a whole -- and sometimes quite large -- category of a very real expense.

Some of these tech companies have impressive growth prospects. It's usually a good idea to at least be somewhat skeptical when that growth is accompanied by little in the way of earnings.

That's especially true when those "earnings" don't include very real expenses.

In the long run, growth can be a fine thing if it is achieved in a way that produces a high return on capital.

That may seem a given, but it is not. Growth comes in many forms ranging from extremely poor returns on capital to extraordinary returns on capital. Some assume it is always the latter.

"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive." - From the 1992 Berkshire Hathaway Shareholder Letter

So, it isn't growth, in itself, that matters. Returns, over the long haul, mostly come down to return on capital and the price that was paid relative to intrinsic value.

That's what really matters.

A good investing result should never be dependent on an exceptional selling price.

Adam

Long positions in MSFT, AAPL, CSCO, EBAY and GOOG established at much lower than recent prices

* NM = Not meaningful. This is because including stock-based compensation the company would have a loss of 29 cents per share.
** It's worth mentioning -- as I have before on more than a few occasions -- that there's really no technology business I'm comfortable with as a long-term investment. Most are involved in exciting, dynamic, and highly competitive industries. That's precisely what makes them unattractive long-term investments. No matter how good business looks today, it's just not that easy to predict their economic prospects many years from now. With the best businesses that's not the case. For me, it's just too difficult to figure out what the economic moat of most tech stocks will look like in the long run. Occasionally, certain tech stocks have sold at enough of a discount to value that it made me willing to own some shares. In other words, their price was cheap enough that it provided a substantial margin of safety. Even then I'm only willing to accumulate very limited amounts. They will remain, at most, very small positions and are generally not long-term investments.
*** As do the analysts. It's hard to understand why someone would choose to ignore these costs for a business like Google but think it makes sense to include them for Apple. Even if there's a compelling explanation/justification it seems wise to be wary of it. 
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Share-based Compensation: Impact On Tech Stock P/E Ratios
Share-based Compensation: Impact On Tech Stock P/E Ratios
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