Inside Financial Services

Stock-Based Comp Is A Real Expense. Companies Should Treat It That Way.

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I thought compensation-related accounting hijinx ended for good when the FASB mandated the expensing of stock options in 2004. I was wrong. More and more companies, I’ve been noticing lately, are asking investors to focus not on their plain-vanilla GAAP earnings, but rather an adjusted number that excludes stock-based compensation. This is a pernicious practice. It needs to stop.

There aren’t many areas where a company management’s interest is more starkly at odds with that of its shareholders than in executive compensation. You’d think, then, that prudent and honest managers would go out of their way to be as transparent as they can on the topic. Too many managers seem to be taking the opposite route. Their argument for excluding stock-based comp is . . . well, actually there is no coherent argument for excluding it. First, stock-based compensation truly is an expense—and usually not a small one, either. Now that so many companies have moved to handing out restricted stock rather than options, it’s not all that hard to quantify, either. And since companies often try to offset the shareholder dilution caused by stock grants with share buybacks, the expense is a de facto cash item as well. There’s simply no reason that investors should not take stock-based comp into account in appraising a company’s profitability or financial strength.

What’s more, stock-based comp is an item where management can be easily tempted to get carried away, at my expense as a shareholder. Yes, I want the people who run the company to own a significant amount of stock, so that their interests are aligned with mine. But there’s no reason to go crazy. If the company pays its CEO $1 million in cash, that’s $1 million out the door. Fine. But if the CEO gets that $1 million in stock, the portion of my ownership is permanently reduced, and the cost of that reduction will compound over time. In an ideal world, management would own enough stock to keep them engaged and motivated to work on my behalf—and not a share more. What exactly that amount of stock is is of course open to debate. But asking shareholders to not consider stock-based comp at all is an invitation to management to err on the high side, and gratuitously overpay themselves.

The last time I recall companies getting into the habit of regularly making self-serving, non-GAAP adjustments to their earnings reports happened at the height of the tech boom in the late 1990s. It was the era of, in Warren Buffett’s phrase, “earnings before bad stuff.” That era didn’t end well recall. Let’s avoid a re-run, shall we? Over the long term, companies will be better off maximizing their earnings and presenting their unvarnished GAAP results as clearly as they can, rather than obfuscating their results with bogus numbers meant to mislead their shareholders.

What do you think? Let me know!

7 Responses to “Stock-Based Comp Is A Real Expense. Companies Should Treat It That Way.”

  1. Avatar gary langbaum

    I totally agree with you that stock based comp is a real cost to the company and potentially to shareholders. Any company which tries to get investors to ignore this factor is probably NOT worth investing in as you should have absolutely no confidence in whatever claims management will be making. Probably the only thing worse than this is a company which is willing to reissue stock incentives at lower price points when the stock is not performing as this really indicates that the management and the Board have total disregard for shareholders. I always was a seller of a company who took this action when I managed funds and always recommended a vote against such actions when it was put onto a proxy statement.

  2. Avatar Bruce Berger

    It seems to me that this practice can only take root if there is an enabler. It would be great if the sell-side analysts ignored the company-provided numbers and focused on the real cost of compensation. That may be wishful thinking.

  3. Avatar Patrick Mulqueeney

    Tom, Great commentary, I could not agree more. If I see a footnote
    in the financials indicating such treatment of stock options, I sell the stock.
    It is indeed an expense and should be accounted for as such. PMM

    • Avatar Marco

      It seems my adopted cuontry, Australia, has only 13 companies this year compared to 18 the previous year. The affect of the GFC was not that severe here but nevertheless affected business. Now that Australia is coming up smelling like roses, the USA investment community is starting to sniff around and are making investments and setting up offices. I expect next year’s numbers to be an improvement. Japan on the other hand is the shocker here, having only 2 companies compared to 24 the year before. Together with the continuing financial mess there and the difficulties forming a stable government, this does not bode well for the future. Might that be The Land of the Setting Sun .

  4. Avatar Markus

    How about a black list with companies trying to fool their shareholders ? It really makes me sick how this vampires are sucking the blood out of good companies . I get the point why earnings are reported pre provisioning but this….
    How about companies report their earnings on what the ceo has dreamed of before he reported the earnings or what management wishes to earn ?

  5. Avatar Randall Grossman

    Well said, Tom. I couldn’t agree more. We are all best off with the greatest transparency in earnings information.

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