In the Financial Times, Aswath Damodaran explains why investors should be skeptical of stock based compensation. The use of stock based compensation is growing among public companies, and is especially prolific in the tech industry. Damodaran writes:
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?”
Read more here.