The drawbacks of paying workers in stock options

It’s tough to find reasons to like this year’s US stock market gains.

Only seven (7) stocks are responsible for the year-to-date advance in the S&P 500, for one thing. And there are signs of deterioration in companies’ earnings quality, as growth in profits isn’t backed up by a corresponding increase in cash flow.

The good news is that tech stocks don’t look all that expensive, as long as you ignore that pesky cash issue — and if you exclude a growing proportion of costs from companies’ earnings.

Morgan Stanley’s tax, valuation and accounting team, led by Todd Castagno, has another look at earnings quality out this week. This matters because with “the pressure to meet expectations in a turning economy, companies tend to stretch adjusted headline earnings vs reported earnings,” they say.

They find that the spread has widened between 1) metrics that meet US regulatory accounting standards, known as Generally Accepted Accounting Principles or GAAP; and 2) companies’ preferred methods of reporting profits, or non-GAAP earnings. From the bank:

To be clear, non-GAAP earnings aren’t necessarily bad or unhelpful — at least for investors in publicly traded companies, which are required to publish a reconciliation of their non-GAAP figures to GAAP standards. And investors often want to exclude one-off events that obscure a business’s underlying profitability.

But the practice becomes less useful when companies start hand-waving away ongoing expenses that have a significant impact on per-share profitability. Like stock-based compensation, also known as SBC.

SBC is responsible for most of last year’s disparity between adjusted earnings and GAAP earnings, the Morgan Stanley analysts found:

They continue:

. . . stock-based compensation is the largest adjustment for Nasdaq 100 constituents. We believe SBC is a true operating and recurring economic cost that investors should consider in valuation. The magnitude and prevalence of SBC has grown over the past decade.

This illustration of SBC expense since 2010, in a separate June 16 note from the same team, nicely shows the increasing importance of SBC for Russell 3000 companies:

US companies have only been required to report SBC as an expense since 2006, as Michael Mauboussin pointed out in April. And lest readers think this is only an issue for proxy season, almost 80 per cent of stock-based compensation is “paid to employees who are not high-ranking executives.”

This is primarily true for tech companies, it seems. They have leaned more on stock options to pay workers over the past decade, offsetting small declines in SBC in other sectors and a very steep decline in SBC for financial-industry workers. From Morgan Stanley’s June 16 note:

This can be good for both workers and companies when the stonk lines go up: The company gets to stay more liquid, and its employees get part of the upside and more skin in the game.

But when markets turn the wrong way — interest rates go up, VC funding runs away, etc — this virtuous cycle can turn into a vicious one fairly quickly. As the bank’s analysts put it:

SBC is a great tool in an up market as it allows companies without much cash on hand to pay competitive total compensation rates to attract and retain talent, better align shareholder and employee interests and morale, and enjoy larger tax deductions. However, in a down market, the reverse is all true creating a negative feedback loop.

Companies start issuing more stock options to make up for their employees’ loss of compensation. This further dilutes the company’s other existing shareholders, further reducing the value of a share (for those who don’t have anti-dilutive holdings and options). This is particularly true if tech stocks go up further and put employees’ other stock options back into the money.

From Morgan Stanley:

The market’s -19% total return in 2022 put many of the SBC awards issued underwater (based on grant date valuations and option exercise prices) and we’ve witnessed many companies “top-up” employees with additional grants to offset their paper losses. Furthermore, many of these awards may not appear in the diluted share count if anti-dilutive, propping EPS up. If the market maintains current levels or extends further and SBC heavy companies become profitable, a wave of shares could hit diluted share counts.

Some of the biggest possible offenders — who had the largest increases in grant amounts from 2021 to 2022 — include Zoom, Pinterest and DocuSign, says MS. Find the full list here. (Some of these companies did deals that could have affected SBC. The list includes AMD, for example, which had a mega-deal to buy Xilinx last year.)

Let’s say that investors simply decide to use GAAP earnings to calculate a company’s EPS. Does that solve the problem? The analysts argue no. They believe that investors should still account for the EPS dilution effects of stock-based compensation:

Is this double counting? A common valuation criticism against our philosophy is that expensing SBC plus penalising a company for EPS dilution is double counting and overly onerous. We disagree as we believe that one must separate and account for (1) awards that have already been granted and (2) awards that are expected to be granted in the future. Awards already granted should burden diluted shares outstanding (denominator), and expected future grants are real economic, operating costs and should burden the numerator.

So what’s a fund manager, Reddit day trader or any type of non-employee shareholder to do?

Our preferred approach for incorporating SBC into valuations is by including the cost in earnings and treating SBC expense as a cash proxy (reducing FCF) in FCF based valuations. When using a multiple or DCF model, we should adequately capture the value implications of future issuance, however many investors are acutely focused on FCF margins and growth, causing some consternation.

A company that dilutes equity with SBC at 3.0% a year does not deserve the same multiple and valuation as another company that dilutes at 0.5% a year, all else equal. When performing a comp analysis, growth must be adjusted for dilution rates . . . 

Companies often use their share buyback authorisations to offset the dilution from SBC. We suggest comparing the amount of any stock repurchased in a period vs. the net SBC cost to see if a buyback is actually returning capital to investors or merely offsetting stock compensation dilution.

Further reading:
— The hidden leverage of stock-based compensation (FTAV)
— The cloud software kings are nuts, when’s the crash? (FTAV)
— Free cash to whom? (FTAV)