From Bill Gurley to Marc Andreesen, Silicon Valley’s smartest are asking if we’re in round two of the dotcom bubble. Many things are different this time around. But one thing is disconcertingly reminiscent of the late 1990s: The way stock based compensation is treated.
You may think, that can’t be! After all, in 2004, the Financial Standards Accounting Board, or FASB, mandated that the estimated cost of stock options be reflected in a company’s income statement, not buried in the footnotes.
But in present-day Silicon Valley, almost every company, from Twitter (TWTR) to Yahoo (YHOO) to Facebook (FB) to Google, (GOOG) presents its earnings excluding the cost of stock based compensation. These are called “non-GAAP” earnings because they don’t follow the accounting principles mandated by FASB.
The battle might have been won. But it seems that the war has been lost. And make no mistake: The numbers can be gigantic.
Maybe it shouldn’t be surprising. For decades, Silicon Valley bitterly fought the expensing of options. In a 2005 piece, accounting analyst David Zion noted that a 1993 proposal to expense got FASB nearly 2,000 comment letters. There was the “Rally in the Valley,” in which Valley denizens marched to protest the possible expensing of options. Congress then threatened to put FASB out of business, and the accountants, not surprisingly, backed off.
One part of the argument against expensing is that it’s hard to value options. Another part is that options are supposedly a non-cash cost. This all was best expressed by Craig Conway, the former CEO of Peoplesoft, (PSFT) who wrote in a 2003 letter to shareholders that “employee stock options have no economic impact on a company.” But there was always a religious aspect to it too. As Reed Hastings, the CEO of Netflix (NFLX), put it in a 2004 opinion piece published in the Wall Street Journal: “Why are the best and brightest fighting good accounting? Because to attack stock options is to attack our Way of Life in Silicon Valley.”
Hastings, along with Alan Greenspan and Warren Buffett, thought options had to be expensed. (And Netflix announced it would expense in 2003.) As Hastings wrote, it was just economic reality. “Think what would happen if stock options given to a supplier were not expensed: Many companies would pay their suppliers in stock options, thereby greatly inflating their profits. When a company pays employees in stock options and does not expense them, profits are similarly inflated.”
In early 2004, after the dotcom bubble had burst, FASB dared another attempt. There was yet another protest march in the Valley. Congress tried to pass a law that has to rank among the most intellectually bankrupt ever, in which options would be expensed—but only for the five most highly compensated employees. (That’s akin to saying that only your biggest costs should count.) But the accountants actually won, or so it seemed.
In his 2005 piece, a prescient Zion wrote, “Companies will likely push hard for pro forma earnings to try to get investors to ignore the cost of employee stock options.”
And here we are. The numbers can be utterly astonishing. Take Salesforce.com (CRM). Over the past three years, the company has reported a total of $658 million in “non-GAAP” earnings. Over the same period, employees netted over $1 billion in cash by exercising stock options. What a business model: Employees make more in cash than the entire company reports in net income!
Thinking about it a different way, Salesforce.com is projected, based on numbers from Institutional Brokers Estimate Service, or I/B/E/S, to make 51 cents a share in its fiscal 2015. That’s “non GAAP.” If you add back the cost of stock options and a few small other things, that 51 cents turns into a loss of 49 cents a share. (Salesforce.com points out in its press release that its peers use the same metrics it does, and that the non-GAAP measures should be read in conjunction with the GAAP measures.)
It is true that stock options are hard to value (as are many things that affect the income a company reports, including the value of long term contracts or illiquid assets), and that companies use a range of valuation methodologies to estimate their cost. There is not a perfect answer.
But they certainly have a cost—a cash cost. In a 2013 research report called “Why Stock-Based Compensation is a Cash Expense,” Dane Mott, an independent accounting expert, put it this way: “Current shareholders should be agnostic as to whether shares or options are sold in the market for cash or issued to employees in exchange for services because either way the current shareholders are being diluted by the economic value of the transferred securities.” Translation: The company is giving away something that has a cash value.
There’s another way to think about the cash cost, which is the cash used to offset the dilution resulting from the exercise of stock options. According to Mott’s analysis, over the past two decades, Adobe (ADBE) has spent almost $11 billion repurchasing shares, mainly to offset the dilution resulting from the exercise of employee stock options. Despite all the cash that has gone out the door, the share count is not much lower than it was 20 years ago. If you consider that cash as an expense of running the business (offset by the proceeds and the tax benefits from the stock issuance) then Adobe’s free cash flow over the last two decades is not a robust $9.3 billion, but rather a meager $2.3 billion.
You might argue this that doesn’t matter, because investors take into account options expense if they want to. And yes, it is much easier to do this today than it was, because the GAAP earnings now are in plain sight.
But there are plenty of investors who don’t look past earnings estimates—in part because the whole system seems to have bought into the idea that stock-based compensation isn’t an expense. Many analysts who follow technology companies don’t include it in their estimates. Those who aggregate estimates into a consensus view don’t include the cost either. IBES, which says that it is the “industry standard relied on by over 70% of the top US and European asset managers,” goes with “majority rule”– that is, if a majority of analysts report their earnings number excluding equity compensation, then by definition that becomes the “consensus” estimate. In another study, Mott found 455 companies where stock based compensation was excluded from the consensus earnings reported by Bloomberg.
A small firm called Zacks Investment Research does include the cost of options in its estimates. “It has not been an easy crusade,” say Sheraz Mian, the director of research at Zacks. “We thought when we started doing something so obvious, well, everyone else would follow. But if you close your eyes and assume stock options don’t matter, earnings are 10% to 15% higher! Everyone goes for that!”
The distortion, of course, has repercussions. As Mott points out, the price-to earnings ratio is the most popular valuation metric. “If it’s based off a metric that ignores stock compensation, then it kind of becomes garbage in, garbage out,” he says.
Comparisons can be fraught, too. Take Microsoft (MSFT) and Cisco (CSCO), both mature technology companies. Microsoft does not back stock options expense out of its earnings, while Cisco does. If you just looked at the Bloomberg snapshot, Microsoft stock appears to sell for about 16 times next year’s consensus earnings estimates, while Cisco trades at about 11 times the estimate. But Ken Broad, a veteran investor who is the co-founder of San Francisco-based Jackson Square Partners, points out the comparison is “apples and oranges” because Microsoft’s headline EPS includes the cost of stock options, while Cisco’s excludes it. So is Microsoft understating earnings, or is Cisco overstating them?
Or consider Goldman Sachs(GS)and Salesforce.com. Both are human resource intensive companies, and both issue a lot of equity compensation. If, like Salesforce.com, Goldman removed stock compensation expense from earnings, in fiscal 2013, its pre-tax earnings would have been about 18% higher. In what universe does it make sense to look at Goldman’s earnings including the cost of stock options, but Salesforce.com’s without?
Back in 2004, a hedge fund manager named Cliff Asness, who is not known for mincing words, wrote a piece called “Stock Options and the Lying Liars who Don’t Want to Expense Them.” At the end of 2013, he listed his top ten peeves in a piece for the Financial Analysts Journal. Coming it at number 9 was “Antediluvian Dilution Deception and the Still Lying Liars.” In it, he wrote, “It’s amazing how hard it is to kill a scam even after you make it illegal to use it on the front page.” Indeed.
Bethany McLean is a longtime business journalist and the co-author of two books, The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron and All the Devils are Here: The Hidden History of the Financial Crisis. A documentary based on the Enron book was nominated for an Academy Award in 2006. McLean is a columnist for Fortune.com, a contributing editor at Vanity Fair and a contributor at CNBC.
