But What Does He Know?

According to Warren Buffet, stock-based compensation should be accounted for as an expense:

I suggest that you ignore a portion of GAAP amortization costs. But it is with some trepidation that I do that, knowing that 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?

Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring “earnings” figures fed them by managements. Maybe the offending analysts don’t know any better. Or maybe they fear losing “access” to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors.

http://www.berkshirehathaway.com/letters/2015ltr.pdf

HG

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Of course stock based compensation is an expense of doing business but it is sill wrong to account for it as an expense on the income statement. It’s bad accounting. The expense is not made by the company but by the shareholders who give the employees some shares. How is this reflected in traditional accounting?

The company issues some shares and gets some cash for them (I’m omitting the intermediary steps)


**Concept         Debit    Credit**
Cash          100,000
Capital                 100,000

Since the number of shares has increased the earnings per share takes a hit. The shareholders HAVE BEEN INFORMED!

If you also add the “compensation” to the P&L statement, you have accounted for the thing TWICE.

Management likes to hide stock based compensation by buying back shares. The accounting is the reverse of the above


**Concept         Debit    Credit**
Cash                    100,000
Capital       100,000

This last entry implies a free lunch which it is not, now the company is downsizing by liquidating some shares. The sellers take their money and run but the remaining shareholders have shares with higher earnings per share.

The situation is back to the original position, the optioned shares have been canceled, earnings per share are back to the previous number. What has changed is that some anonymous shareholders have been replaced by employees who typically sell their shares back to some anonymous shareholders. In other words, the compensation was not paid by the company but by Mr. Market!

Why then does Warren Buffett hate stock based compensation so much that he is willing to destroy proper accounting? Because, during the first stage it goes against his investing thesis which is to accumulate shares. If he were to buy back those shares the dilution would disappear. But this goes against his investing thesis as well which is to hoard cash, other people’s cash.

Denny Schlesinger

Note: The accounting is not exactly a wash depending on the cash paid by the optionees and the price paid for the shares bought back but in the grand scheme of things it’s a fairly unimportant number.

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Hi Denny, I think that in general you are correct. The problem with your method is that the additional shares aren’t accounted for until the options are exercised. To my knowledge the diluted share count does not include any open, unexersized options. This is the part that Warren or anybody else should not like. By definition there is an overhang of unexersized options sitting out there that will dampen stock price increases going forward and it is not accounted for until they are exercised.

It is as if you sold at the money calls on a portion of your stock portfolio and acted like your overall position did not change when clearly it has.

Now for this board, I totally get why Saul doesn’t account for options and that is because the market doesn’t and since he is trying to drive portfolio growth versus the market price, it is probably correct to back it out.

Randy

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The problem with your method is that the additional shares aren’t accounted for until the options are exercised.

Hi Randy,
Are you sure about that? I thought that that was the definition of total diluted share count: it includes all potential shares.

If they only counted options are were already exercised, it wouldn’t be “diluted”, after all, it would then be the actual current share count.

Saul

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Hi Saul,
Actually, no I am not sure. I thought I recalled reading that diluted share count included vested shares cr some other portion of options but not all. I could be mistaken and if the diluted count changes as soon as options are given, I am okay with not taking a hit to expenses.

Randy

The problem with your method is that the additional shares aren’t accounted for until the options are exercised. To my knowledge the diluted share count does not include any open, unexersized options.

CMF_BigECat, thanks for your reply but according to Investopedia you are wrong.

What are ‘Fully Diluted Shares’
Fully diluted shares are the total number of shares that would be outstanding if all possible sources of conversion, such as convertible bonds and stock options, were exercised. Companies often release specific financial figures in terms of fully diluted shares outstanding (such as the company’s profits reported on a fully diluted per share basis) to allow investors the ability to properly assess the company’s financial situation.

http://www.investopedia.com/terms/f/fullydilutedshares.asp

Now for this board, I totally get why Saul doesn’t account for options and that is because the market doesn’t and since he is trying to drive portfolio growth versus the market price, it is probably correct to back it out.

The reason to ignore the theoretical market value of outstanding options and warrants as calculated by the Black Scholes option pricing method is that it makes no practical sense whatsoever and distorts proper accounting. This price is driven by the current price of the shares and with volatile stocks the P&L statement gets whipsawed. In every case, if the option or warrant or convertible is exercised the company gets cash for new shares* which are already included in ‘Fully Diluted Shares.’ It’s a piece of Ivory Tower fiction. All you need is the diluted share count which includes these potential shares. That is already in place.

Denny Schlesinger

  • This is the exact reason why I only sell covered calls, in the worst case I always get cash for my shares. How can that be bad?
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“…according to Investopedia”

What are 'Fully Diluted Shares
Fully diluted shares are the total number of shares that would be outstanding if all possible sources of conversion, such as convertible bonds and stock options, were exercised. Companies often release specific financial figures in terms of fully diluted shares outstanding (such as the company’s profits reported on a fully diluted per share basis) to allow investors the ability to properly assess the company’s financial situation.

Thanks for looking that up Denny. As you know, I agree with you. Since the additional shares are already included in diluted shares, taking stock based compensation as an expense as well is clearly double counting it. It’s why I use adjusted earnings.

Saul

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Saul, you are most welcome! Investing is hard enough without FASB skewing the data.

Denny Schlesinger

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captainccs,


The company issues some shares and gets some cash for them (I'm omitting the intermediary steps)

Concept         Debit    Credit
Cash          100,000
Capital                 100,000

Since the number of shares has increased the earnings per share takes a hit. The shareholders HAVE BEEN INFORMED!

If you also add the "compensation" to the P&L statement, you have accounted for the thing TWICE.

Management likes to hide stock based compensation by buying back shares. The accounting is the reverse of the above

Concept         Debit    Credit
Cash                    100,000
Capital       100,000

You are showing equal dollar amounts for the issuing and buying back of the shares. But the strike price of the option is often far under market value. So the company may indeed get the cash (strike price when the employee purchases the shares by exercising his/her option), but the share buyback must be made at market price…typically after the options are exercised. In most tech companies, that means they are usually (not always!) buying those shares back at a much higher price than they took in, thus incurring a net loss. THAT loss is not reported anywhere that I aware of. I would love to know where to find it if I am wrong!

Tiptree, Fool One guide

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You are showing equal dollar amounts for the issuing and buying back of the shares. But the strike price of the option is often far under market value. So the company may indeed get the cash (strike price when the employee purchases the shares by exercising his/her option), but the share buyback must be made at market price…typically after the options are exercised. In most tech companies, that means they are usually (not always!) buying those shares back at a much higher price than they took in, thus incurring a net loss. THAT loss is not reported anywhere that I aware of. I would love to know where to find it if I am wrong!

Tiptree, you are right and thanks for pointing out that the dollar amounts don’t need to match. Indeed the shares are sold at a deep discount and the discount is what constitutes “employee revenue,” not the market price of the shares.

I’m not denying that stock options are labor costs. What I’m against is commingling company accounting with shareholder accounting. I would like to remind that the stock option plans have to be approved by the shareholders. It’s their shares that are being diluted but they want it otherwise they would vote against it.

“What does Buffett know?” That he dislikes stock options but that is NOT a good reason to screw up GAAP more than they already are.

Denny Schlesinger

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