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!