Stock-Based Compensation and Tech Stocks: What You Need to Know

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For anyone who invests in technology stocks, an understanding of stock-based compensation and how it can affect a company's financials is critical. Stock-based compensation, or equity compensation, is a method used by companies to reward and retain employees. Fast-growing technology companies use it as a way to attract engineering and executive talent, with the potential for major stock appreciation in the future compensating for lower cash salaries today.

Stock-based compensation comes in a few different flavors. Stock options, which give employees the right to buy shares of the company's stock at a predetermined price after a vesting period, are one popular form. Restricted stock units, which result in the company distributing common shares directly to employees after a vesting period, are another. In both cases, the vesting period creates an incentive for employees to remain at the company for at least a few years, and the resulting ownership stake is supposed to align the interests of executives with those of the company.

How stock-based compensation affects earnings

Prior to 2005, companies were not required to treat stock-based compensation as a cost under generally accepted accounting principles, or GAAP. Disclosures in the footnotes of financial reports were required, so investors weren't completely in the dark, but stock-based compensation had no effect on the bottom line. Stock-based compensation does increase the total number of outstanding shares, making each share represent a smaller ownership stake in the company.

The rules were eventually changed by the Financial Accounting Standards Board to reflect that stock-based compensation represents a real expense, despite the fact that it's non-cash. Today, companies are required to expense stock-based compensation during the period in which its granted. When a company reports its GAAP results, stock-based compensation is included in the relevant expense categories.

Technology companies that rely heavily on stock-based compensation to attract employees often report large GAAP losses due to this rule. A few examples are social network Twitter (TWTR), network security equipment vendor Palo Alto Networks (PANW 1.05%), and software-as-a-service provider Workday (WDAY -0.75%).

Technology companies, particularly those unable to produce a GAAP profit, often report non-GAAP figures along with the required GAAP results. These non-GAAP numbers back out various items, some of which are more reasonable to exclude than others. Stock-based compensation is almost always backed out, and the result is that an unprofitable company can claim to be profitable, at least according to its own fairy-tale numbers.

Data source: Twitter, Palo Alto Networks, and Workday quarterly reports.

GAAP accounting isn't perfect, and there are some adjustments that are often reasonable to make. But stock-based compensation is not one of them. Warren Buffett put it best in his latest letter to Berkshire Hathaway shareholders:

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?

Unfortunately, many analysts perpetuate the game that technology companies play with earnings by providing estimates on a non-GAAP basis. Investors who don't look past the headlines are led to believe that companies like Twitter, Palo Alto Networks, and Workday are profitable. They're not.

Stock-based compensation also complicates free cash flow, which is sometimes touted as an alternative to GAAP earnings. Free cash flow is a useful number, as it represents the amount of cash a company's operations generate minus capital expenditures. But since stock-based compensation is non-cash, it gets added right back in. When the only source of free cash flow is stock-based compensation, that free cash flow fails to reflect the company's true profitability.

Handing out massive amounts of stock-based compensation has one major downside for companies. In the event that the stock price crashes, retaining employees, who would then be receiving compensation in a currency that's losing value, becomes a challenge.

Twitter is currently struggling with this exact problem. The company's stock has lost more than two-thirds of its value since April of 2015, when I warned investors to stay away. This deep slump forced Twitter to offer additional cash and stock bonuses earlier this year to employees in an effort to keep them on board, raising costs and diluting shareholders further.

For investors, the key takeaway is this: stock-based compensation is a real expense, and should be treated as such. Ignore the non-GAAP numbers that tech companies tout as superior, and ignore analyst estimates that fail to account for all of a company's costs. Don't assume that free cash flow is a reasonable representation of profitability, because it's often not when stock-based compensation expenses are high. The number that a company wants you to focus on is rarely the number that you should.