Buyers Beware: risk of stock option expenses in tech stocks

PayPal’s second-quarter financial results came out on July 26 . Revenues grew to $3.14 billion, an increase of 18 percent over the same period last year.

According to the Times ,“PayPal’s favored earnings-per-share measure came in at 46 cents per share, 3 cents more than Wall Street analysts had expected.“

Earnings are up and the stock price hit a new high. Great. What could go wrong ?

Let me back up a bit…

There are three financial statements that companies need to track. The balance sheet shows the assets and liabilities of the company. So any capital expenditures like buildings and factories go into this bucket.

The cashflow statement shows how much cash the company has at the end of the quarter. If you don’t have any cash to pay your employees, they are basically bankrupt.

The income statement that shows how much money the company makes and the expenses they need to pay. This is how Wall Street comes up with earnings per share (EPS).

So you can imagine, earnings are really important. The article above explains it like this : “exceeding analysts’ estimates — “beating the number,” in Wall Street parlance — is crucial for any corporate leader interested in keeping his or her stock price aloft. Even the smallest earnings miss can send shares tumbling.”

Ok so how does employee stock option expense fit into all this ?

From the company’s perspective, employee stock expense is not easy to calculate.

  1. The employee may not want to exercise even though the options are “in the money.” (exercise price is cheaper than the stock price) Unlike stock options in the public market, an employee may not want to exercise for personal reasons. Perhaps the employee is getting married or they are buying a house?
  2. The company doesn’t know when their employees will leave the company and anytime an employee leaves the company, they need to adjust the expense number.

From the investor’s perspective, it’s impossible to value to two companies similar in size unless you count the equity awards that are given to employees. If company A gave our all cash bonuses and company B gave out all equity awards, is it fair to think company B is better, if they didn’t get penalized for employee equity awards?

How does employee equity affect shareholders value ?

As more employees exercise their options or their restricted stock units get settled by the company, the investors’ portion of the pie get smaller.

Think Snapchat. When employees own stock in the company, they may sell their stock as a cohort which drives the stock price down.

The fear of the lock up expiration date (when employees can sell their stock after an IPO) on July 30th was probably one of the factors that made the price do this. (They have other problems that they need to solve).

So what are tech companies doing to hide their stock option expenses?

They began providing alternative earnings calculations without expenses alongside results that were accounted for under GAAP.

The non-GAAP statements — called pro forma numbers — often exclude expenses like stock awards and acquisition costs.

As long as companies also showed their results under generally accepted accounting rules, the Securities and Exchange Commission let them present their favored alternative accounting.

What should the investors do ?

Always look for the GAAP numbers. Try to compare their expenses to other comparable companies. And whatever you do, don’t just read what equity analysts say. Do your own research. Listen to Warren Buffet:

Price is what you pay. Value is what you get.

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