Back in 2014, I wrote an article that discussed Google's, now Alphabet’s (GOOG) (GOOGL), use of non-GAAP earnings when reporting financial results to shareholders. The most notable exclusion from the company’s non-GAAP earnings was stock-based compensation, or SBC.
Looking at the company’s most recent results (here), we can see that management provides a near identical justification for reporting non-GAAP financials as it did in 2014:
“Non-GAAP financial measures provide meaningful supplemental information regarding our performance and liquidity by excluding certain items that may not be indicative of our recurring core business operating results, such as our revenues excluding the impact for foreign currency fluctuations or our operating performance excluding not only noncash charges, such as SBC, but also discrete cash charges that are infrequent in nature…”
Of course, there’s nothing “infrequent” about stock-based compensation expense: it’s been a recurring – and rapidly growing – expense at Alphabet for many years.
In 2010, stock-based compensation totaled $1.4 billion, or 4.7% of revenues.
In the ensuing five years, revenues have increased ~150% to $74.5 billion in 2015. The number of full-time employees at the company has increased at a comparable rate.
Stock-based compensation, on the other hand, tripled between 2010 and 2015, to $5.2 billion (equal to 6.9% of revenues). Clearly we’re not talking about a rounding error.
I don’t think the growing use of stock-based compensation should surprise anyone: if you don’t view it as an expense – and Wall Street agreed with you – wouldn’t you favor it as well?
I find this particularly interesting because Alphabet’s founders are fans of Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio). They famously noted, in their IPO filing, that their “Owner’s Manual” for Google shareholders was inspired by Buffett’s essays in his annual reports and his “An Owner’s Manual” to Berkshire Hathaway (BRK.A) (BRK.B) shareholders. That makes me wonder if Larry Page read this section of the 2015 Berkshire Hathaway shareholder letter:
It has become common for managers to tell their owners to ignore certain expense items that are all too real. "Stock-based compensation" is the most egregious example. The very name says it all: "compensation." If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?
Of course, many tech companies agree with Alphabet: Stock-based compensation expenses can simply be ignored. Again, this impacts behavior: as noted in this past weekend’s Wall Street Journal, Standard & Poor's 500 tech companies reported a nearly 20% gap between their GAAP and non-GAAP earnings in 2015 (I'll bet you can guess which measure was higher). For every dollar of reported earnings, the GAAP income statement showed just 84 cents in net profits. That’s enough to move a stock from 20x “earnings” to 24x earnings.
The difference between GAAP and non-GAAP earnings for S&P 500 tech companies was twice as wide in 2015 as it was in 2014. While we don’t have a breakdown, you can feel safe in assuming SBC plays a big role in that discrepancy.
It’s important to recognize that many tech companies do not play this game: Microsoft (MSFT, Financial) and Apple (AAPL, Financial) are two large competitors of Google that come to mind. Oddly, Wall Street analysts do not make the effort to adjust the figures of peers to compare results on an apples-to-apples basis: they simply accept whatever presentation management provides.
There could be a couple of explanations why. Maybe the analysts don’t want to lose access to management. Or maybe they don’t want to be the sole analyst with an outlier EPS target for the company (at Google, it’s a swing of more than $5 in EPS due to SBC). Or maybe they don’t know any better (or care) and simply accept whatever number management puts on the board.
No matter the answer, I agree with Buffett’s conclusion:
“Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors.”
Conclusion
Regardless of the analyst’s culpability, the ultimate responsibility falls squarely on management’s shoulders.
Here’s what Buffett said a few years ago when asked how he approaches his shareholder letters:
“I try to think of my shareholders as my partners. I try to think of the information I would want them to send me if they were running the place, and I was the shareholder. What would I want to know? This is what I tell them.”
Larry Page and Sergey Brin have been writing annual shareholder letters since 2004.
They’ve spent time discussing the crucial role of the company’s employees (“Googlers”) and how the investments they make keep them happy: “great food, high quality medical care, gyms and other fitness facilities as well as cool workspaces that bring people together.” I’m assuming the cost for employee lunches and medical care are in the non-GAAP financials.
Amazingly, the billions spent on stock-based compensation – which are excluded from non-GAAP earnings – have never been directly addressed in the founder’s letters. CFO Ruth Porat apparently has no issues with the exclusion of SBC, either; when she has some time, she might want to call her replacement at Morgan Stanley (MS) and let him know an easy way to magically boost EPS.
The Financial Accounting Standards Board (FASB) in the U.S. settled this argument over a decade ago. There are a number of companies in corporate America – particularly in technology – that should either do some explaining or accept reality and start reporting stock-based compensation as an expense in all earnings calculations.
