Accounting vs Economic Reality Part 1: Stock Based CompensationRoberto Sanchez
This will be the first in a series of articles covering a fundamentally important concept in equity investing: that there is a difference between reported accounting numbers and actual economic reality.
GAAP (Generally Accepted Accounting Principles) is the accounting you will find if you open most publicly reported financial statements. These are the numbers commonly used by the investment industry to assess the financial health and valuation of a given company. These are the same numbers that drive quantitative, factor-based strategies and the decisions of many active managers. But for the long-term, genuine investor, these numbers (if taken at face value) are often very misleading.
Now certainly GAAP accounting is an important aid in understanding a business, but it should be viewed as one input in a much broader process of truly understanding the economics underpinning any given business. Without this understanding, you may find yourself making investment decisions based on accounting numbers that aren’t representative of business reality. In other words, we always need to understand the business behind the numbers, to be able to properly make use of the numbers.
There are many examples where an over-reliance on publicly reported accounting statements can lead investors astray. Through this series we will cover what we see as some of the most important – starting today with our thoughts on stock-based compensation accounting.
Stocked Based Compensation
Many early-stage companies incentivize their employees by offering stock compensation in the form of stock grants and stock options. This serves two purposes: 1) it allows the company to attract high quality talent even if it couldn’t afford to pay the high cash salary, and 2) it contributes to employee loyalty, as those employees typically have to remain with the firm for a number of years in order for their stock compensation to vest.
But as we all know, costs don’t just disappear, and this technique just transfers the economic cost to the shareholders since issuing stock has the very real negative impact of diluting their ownership. And while not as immediately obvious as salary expenses, dilution is a very real cost. The only way to offset this dilution is for the company to buyback the same number of shares it issues to employees – using cash.
For example, if a company issues 1000 shares via stock grants/options, then it needs to buyback and cancel 1000 shares to avoid any dilution. But to do this buyback requires real cash, so that stock compensation has just become a real cash expense again. The cash cost has just been transferred to a different part of the income statement – but it’s still there. The other option is for a company to just kick the can down the road- dilute the shareholders now, and then hope there is sufficient cash generation in the future to fund the buybacks needed to offset past dilution, or to pay the cash salaries. This is the option chosen by many companies.
But whichever way a company chooses to approach this, there just isn’t a way of escaping the real cost of labor. A company either 1) pays employees in cash now, 2) it pays them in stock and spends cash to buyback equivalent shares, or 3) it makes the shareholders pay via dilution.
Now, it is positive that accounting rules require companies to include this stock-based compensation within their P/L expenses, therefore ensuring that this very real cost is included within a company’s reported earnings number (a rule that did not always exist historically). However, there is still an issue with stock-based compensation accounting when it comes to measuring cash flow.
Cash flow-based stock analysis is often lauded as the most defensive, grounded, form of company analysis. The mantra goes that we as investors should always look to cashflows because earnings can be manipulated, but cash doesn’t lie. That is mostly true- but while cash may not lie, it can certainly mislead you.
The problem is that stock-based compensation inflates reported cash flow numbers. Consider that many companies choose to pay employees in stock without buying back shares to offset dilution, so technically there has been no cash out the door. However, this technicality does not magically change the economics of your business; the cost has simply been transferred to your shareholders– so we need to include it in our analysis.
We aren’t saying that stock-based compensation is bad (some very successful companies have employed it) we are just saying that investors need to be aware of the risks that come with it rather than simply trusting the cash flow numbers in annual reports as the economic truth.
And aside from the issue with the cash flow numbers, when a company does huge buybacks this is often viewed as a positive by the market, but what if the buyback just accounts for the amount of stock the company is issuing in order to keep their employees? Or what if it would take them years of buybacks to offset the huge dilution they’ve implemented over the last few years? In either scenario, it isn’t a real buyback, it’s more a payment of present (or past) labor expenses.
Example: Snap Inc. (SNAP)
Let’s look at a real-life example. In 2020 SNAP recorded revenue of $2.5bn, and it recorded an expense of $771m for stock-based compensation, or 31% of revenue. In the same period, it recorded positive cash flow of $25m. So, the company managed to generate $25m in cash, but only because it took $771m of real labor cost and didn’t pay it in cash – it paid it out by issuing stock.
You could argue the ‘real’ cash flow of SNAP should have been -$750m. And how much of that $771m stock did they buyback to offset the dilution impact? Zero. So, the shareholders effectively paid $750m worth of SNAP’s labor bill. In other words, kicking the can down the road – diluting existing and future shareholders in order to keep their current employees happy. Instead, if SNAP had to pay its real labor costs up front it, would need to find an additional $750m each year.
There is nothing wrong with using equity or debt to fund businesses in the early years, but there is something wrong with saying a company is generating $25m of cash flow, but only after ignoring their biggest expense. Any analyst or fund manager relying on accounting ratios or even stated cash flow numbers will be missing the underlying economic reality here.
Now compare this to another real-life example in Facebook (FB). Facebook recorded 2020 revenue of $86bn, and stock-based compensation expense of just over $6.5bn, for a much healthier 7.6% of revenue. In addition, Facebook bought back just under $6.3bn of stock over the same period, almost entirely offsetting the dilution impact.
The difference to the SNAP example is that Facebook is producing sufficient cashflow to cover the labor expense, and by using stock-based compensation it has effectively just shifted that expense from one area of the cash flow statement to another. Now, when Facebook was a much younger company it looked more similar to SNAP today. In the future SNAP may well grow into their labor expense as Facebook did, but our point is that comparing companies without making cash flow adjustments for stock-based compensation often paints a misleading picture.
The key thing for investors to think about is: what is going on with the underlying business? What are the accounting numbers not showing me? Think of this in a real sense- if we were to be in a position to buy SNAP and take it private, we’d only be able to do so if we had a plan to support the $750m hole in their cash flow. So, that would need to be factored into the valuation we’d pay for the company.
The point here is that investors cannot rely simply on reported numbers – they have to understand the true economics of the businesses they are investing in. For us, we always view stock-based compensation as a real cash cost (through dilution or buybacks) to be accounted for. Short-cut methods like ratio analysis, topline multiples, reported financials, etc. can be very misleading.
Always focus on the business itself, not just on the numbers.
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