should this be done? what i remember from the CFA exams is that this should be done when it is not a recurring thing. like when you IPO and hand out stock like candycanes at Christmas. now that almost all companies (Tech, Health Care, Energy, etc, etc) offer stock based compensation as a normal part of operations, does removing stock based compensation artificially lower the P/E and make it less useful when comparing to the past? the last 3 companies i’ve looked at (2 in Tech and 1 in Energy) used stock based compensation as ~30% of total comp to shareholders, or roughly 10% of total expenses on average. if you’re trying to compare companies, why would you remove a major expense?
i’m pretty sure this only effects comparisons between individual securities as S&P500 multiples are based on reported earnings. still, why do analysts do this?
Excellent question. Stock based compensation is a real expense but whether or not you should adjust for it is debatable. It’s never NOT a real expense; however, whether it should be a point of discussion when analyzing a company totally depends on the situation.
For example, you should adjust for it when they mean something for apples-to-apples comparisons, such as a mature growth or mature company, and different companies use varying degrees of stock based compensation for their COGS and opex. In a healthcare example, you might have one orthopedics company that uses a higher mix of stock comp to incentivize their sales force. So on a non-GAAP basis, that company might appear to have higher operating margins but normalizing for the stock comp, their margins might even be lower than peers if they are using a ton of stock based comp.
On the other hand, focusing too much on whether including stock option expense can often lead to negative GAAP operating income or net income can cause you to miss the forest for the trees in other instances. For example, since you mentioned tech, frequently people will criticize SaaS companies trading at 6x+ EV/sales multiples when they aren’t making money. They think this is a ludicrous valuation.
However, what people don’t realize is that these SaaS companies need to invest in the future, and more importantly there is a difference in the SaaS model where expenses have to be incurred upfront while revenue streams can go for a very long time in the future, sometimes even increasing. So if you were to say something, as people often do, about how a company is not making any real money today, it’s because they are overlooking a very key point about the business model. Furthermore stock options expense also sometimes doesn’t matter in stuff like subscale storage or networking equipment companies. Nobody cares if their GAAP earnings are negative because if they have a real technology and business model, eventually they will get bought at a massive multiple and a significant amount of that opex (especially sales and marketing and G&A) will be stripped out anyway.
Hope this helps…I have a lot of experience with many of the industries you mentioned and the point on stock based compensation comes up a lot when debating ideas with investors, and frequently investors horribly misvalue companies when they don’t pay attention to the differences in business models or industries. Great question.
thanks for the input numi. it did help a bit. i understand removing it if its one-time or above average for a given period (“upfront” to invest in talent or whatever, like you said) but to do it normally just doesn’t feel right.
the problem with the SaaS companies is the question whether they will ever be able to stop issuing stock for comp to the degree that they do it now? if they had to pay cash for comp, many of them would have gone under by now as their fates would be tied to general investor confidence. this was basically the case during the tech boom and why it ended up crashing - you couldn’t pay your employees with worthless stock and investors wouldn’t buy stock anymore.
can you explain why you would remove stock based comp for a mature company? i’m assuming most mature companies would issue it at a pretty steady rate over time so it should be a smoothed expense already.
i guess my question is why don’t we “add in” stock based comp when comparing companies, instead of removing it?
If you bought the whole company and removed the option plan, what would management require in cash compensation? Any share-based compensation over that number should be adjusted.