It still amazes me!

It still amazes me!

During the discussion on Shopify and others, I kept seeing people angrily declaiming ridiculous things like:

These companies just use stock based compensation to say they made a profit.

or

They give all that stock based compensation to show a profit.

or

Most of that profit is just stock based compensation.

How can people have no idea of what the difference between GAAP and non-GAAP is all about?

Do these people actually believe that the company really had a cash loss, and then gave away stock grants, and magically that allowed them to show a profit??? What nonsense!

If a company has a non-GAAP profit but a GAAP loss, what that means in the real world, is that the company made a cash profit, put the cash in the bank, real cash, REAL MONEY, real cash!

Then GAAP comes along and says, “Well, but you paid stock based compensation. Yes, we know that that is accounted for in stock dilution and an increased stock count, but we, in our wisdom, decided to double-count it and make believe it was a cash expense, and that therefore you didn’t make that profit. Yes, we know the cash is in your account, but we decided to punish you for being bad boys by making believe it isn’t.”

But yes, they made a cash profit, and the money is in the bank!

Now, let me assure you, I don’t like companies who dilute my stock hugely each year, and some I avoid them because of it, but I’m aware that these rapidly growing young tech companies don’t have a lot of cash and can’t afford to pay large salaries, and the way they get bright young tech people to sign on is to give them a stake in the company. That’s life.

Saul

For Knowledgebase for this board,
please go to Post #17774, 17775 and 17776.
We had to post it in three parts this time.

A link to the Knowledgebase is also at the top of the Announcements column
that is on the right side of every page on this board

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http://aswathdamodaran.blogspot.com/2014/02/stock-based-empl…
counter-argument

If it matters, I’m no accountant, so I’m not going to get into the idea of GAAP vs. non-GAAP other than to suggest that using your language here -

Now, let me assure you, I don’t like companies who dilute my stock hugely each year, and some I avoid them because of it, but I’m aware that these rapidly growing young tech companies don’t have a lot of cash and can’t afford to pay large salaries, and the way they get bright young tech people to sign on is to give them a stake in the company.

leads to the obvious observation that SHOP has a LOT of cash and doesn’t fit your definition of a ‘young tech company (that) don’t have a lot of cash’

Besides, we all know SHOP is not being valued on traditional metrics, but suggesting that having a revulsion against stock based compensation is not entirely justified is like suggesting ‘I like lice and I think anybody who doesn’t like lice is wrong’. Nobody in their right mind likes share based compensation given the enormous opportunity to abuse it.

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For anyone with a particular revulsion to either stock-based compensation or to excessive stock dilution, I would strongly recommend taking a close look at Ubiquiti Networks.

From a quick look at the financials over the past several years:

2013 weighted average # of shares - 88 million
2017 Q4 weighted ave #(ending 6/30/2017) - 80 million shares
Currently - about 77.something million shares (after most recent buybacks)

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Stock based compensation has two elements. (1) it is cheap cash that gives a public company a clear advantage to raise finances in order to compensate and motivate talent, and make acquisitions or strategic initiatives without having to repay anything; (2) however it is also expensive.

As an example, I believe SHOP diluted by 16% in the past year (although much of that may have been from the cash raise for money just sitting there. Theory being either that the bank interest was worth the dilution, or SHOP knew they were overvalued and therefore they took advantage of the situation), however you look at it. To use it as an example for every $1 of earnings per share SHOP would have had, it is now worth $.84 a share now. Next year if they dilute 10% that same $1 is now down to .756 per share, and next year if they dilute 10% (as this is a regular course of business) that same $1 in earnings is now worth $.68 per share.

That is not “cheap”. It is “cheap” like a consumer might consider credit card financing, until they start putting too much credit on the card and it becomes overwhelming over the course of a few years.

It has been successfully used by the best of companies, so I have no problem with it, but to say it is without costs or is "cheap’ is not accurate.

I guess also, that I am spoiled when looking at companies like Nvidia or Arista or Align who print cash and not shares per se (although except for Arista, Nvidia for example, is not shy about some share dilution, but they also buy these shares back as well).

Yes, SHOP, as an example, may be able to buy back those shares with the cash it raised at a lower price, but then that is no good for the shareholders who bought at higher prices, if SHOP’s reason for the secondary was their recognition of the shares being overvalued. Smart management, then yes. Good for shareholders? No. Elon Musk has had a similar issue, where at least twice he has let slip out that he thought the shares were overvalued…whoops. But not unheard of.

I am making no comment if SHOP is overvalued or not. I see it as an enterprise to revenue of 9x on 2018 revenues. Much less than trailing valuations. But I also see not much leverage in the business model (my opinion) EXCEPT, one can see how there can be real leverage IF Shopify Plus becomes much more material. Shopify Plus is not SHOP’s core mission, but SHOP is starting to move that way, and as I have mentioned multiple times, it is not the merchant count, but quality that matters, and SHOPIFY PLUS is the future of SHOP.

So placing a value on SHOP as enterprise to revenue is much too simple.

Anyways, stock options are good and bad.

Tinker

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And what does the stock compensation get you? More and better engineers.
Just pulled off the CEO’s twitter feed…

Shopify is the #1 tech employer in Canada: https://twitter.com/Hired_HQ/status/925308123027566592

Shopify is the #3 employer brand after Spacex and Google (albeit not based in Toronto): https://twitter.com/craigmillr/status/923551557282562048

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<<<And what does the stock compensation get you? More and better engineers.>>>

It may be too high of a standard, but Arista gets the best engineers, amazingly enough, without paying much in terms of stock options.

Nutanix on the other hand…yikes! But they do draw the best.

SHOP has to do what they think they need to do. So I have no problem with it. I just wonder how Arista does it the way they do? I think there is a lesson that can be learned there.

But if that is what it takes, except in rare circumstances to obtain the best talent, then I am in complete agreement!

Tinker

I just wonder how Arista does it the way they do?

As you have pointed out, Arista is creating gobs of cash. I’m sure they just pay great talent with great salaries to keep them happy and focused. But in their early beginnings, this may have been a problem…not sure.

Doesn’t seem to be a problem any longer.
I am surprised the market isn’t happier with the results from yesterday which were absolutely stellar.
Gave me an opportunity to increase my holding again today after increasing them in the after hours yesterday.

I’m pretty full up with ANET right now, but I have to say it is tough not to buy more.

Take care,
A.J.

If it matters, I’m no accountant, so I’m not going to get into the idea of GAAP vs. non-GAAP other than to suggest that using your language here -

I studied and practiced accounting even if I’m not a certified pubic accountant. Expensing stock based compensation is a terrible piece of bad accounting. It’s a bit complicated but I’ll try to simplify it.

There is no question that stock based compensation is an expense that the stockholders have to pay. That’s not the issue. The issue is the proper way to account for it. The first concept that one has to have in mind is that the company is a separate entity from its stockholders.

Imagine this situation. You decide to start a business but you need two people to do the work for you, It’s a grand idea but you don’t have the money to pay these people a salary. So you make a deal with them as follows:

“Guys, I need your help to start this business but I can’t pay you a salary. Instead I’ll give each one of you one third of the company.” They agree so you go to a lawyer to do the paperwork. You establish the company with 300,000 shares par value $0.01. You pay them in full, $3000.00. You transfer 100,000 shares to each of your new partners.

How do you account for it? The company has not yet done anything. You did a deal with two individuals. The “stock based compensation” needs to be accounted for in your accounting, and in your partners’ accounting for tax purposes. The company is entirely unaware of how it was established.

If you are with me up to now, I’ll explain what’s wrong with expensing “stock based compensation.” You are putting in the company’s books entries that belong in the shareholdres’ books! You are commingling the accounts of separate individuals, the company and the shareholders. In proper double entry accounting all you can do is enter the option transactions. These entries will ALL go in the Balance Sheet, NONE will go in the Profit and Loss Statement. Even done that way, GAAP using “mark-to-market” accounting can really distort the Balance Sheet as the stock fluctuates in the market and you have to reflect the “gain or loss” in the Profit and Loss Statement. Thank heaven that mark-to-market was abolished in 2009. According to Brian Wesbury, the stock market recovered in 2009 after it was abolished.

Why Mark-To-Market Accounting Rules Must Die
www.forbes.com/2009/02/23/mark-to-market-opinions-columnists…

A mark-to-market history lesson
ftalphaville.ft.com/2009/03/13/53587/a-mark-to-market-histor…

Denny Schlesinger

PS: The scenario I painted above is not fiction. That’s how I set up my software company to assault Silicon Valley.

www.mactech.com/articles/mactech/Vol.03/03.11/HelpSystem/ind…

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It may be too high of a standard, but Arista gets the best engineers, amazingly enough, without paying much in terms of stock options.

Hi Tinker, perhaps Arista pays the same amount of SBC as Shopify does, dollars-wise, to each hire, but it looks like much less because they have a larger market cap, two and a half times more revenue, etc, so it’s less as a percent of revenue, and it’s less dilution. I don’t know that for a fact, it’s just a speculation…

Saul

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Have folks stopped studying financial statements? I’m a bit flummoxed by some of the comments offered regarding earnings, cash management and share count. How 'bout we examine the financial reports?

http://d18rn0p25nwr6d.cloudfront.net/CIK-0001594805/c30590d1…

Let’s cut right to the chase. On page 3, “Condensed Consolidated Statements of Operations and Comprehensive Loss” we see that SHOP suffered a comprehensive LOSS of $6,776,000. That’s right, folks, SHOP operated at a LOSS. The share count (for GAAP purposes)? It’s right there on that page: 98,777,975. If you want to see how the share count grew, just turn the page. On page 4, “Condensed Consolidated Statements of Changes in Shareholders’ Equity” one can see how the share count climbed from 80,089,858 in December, 2015 to 99,272,310 as of September 30, 2017.

Does SHOP have money in the bank? Yes, it does. But the money does not represent profits from operations. No, that cash resulted from the sale of shares. In May 2017, the Company completed a public offering, in which it issued and sold 5,500,000 Class A subordinate voting shares at a public offering price of $91.00 per share. Subsequently, in June 2017, the Company issued and sold 825,000 Class A subordinate voting shares at the same price as a result of the underwriters’ exercise of their over-allotment option. The Company received total net proceeds of $560,057 after deducting underwriting discounts and commissions of $14,390 and other offering expenses of $1,128.

Frankly, I don’t care all that much about stock-based compensation. Most corporations indulge in it to some extent. As an investor, I’m interested in whether or not the SBC is reasonable in light of operating performance. Given that SHOP is a money-losing operation, I think the SBC is overly generous. Your mileage may vary.

C’mon folks, investing is a serious undertaking. It’s time to get serious about studying the financials.

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It’s time to get serious about studying the financials.

The financials are the past. The future starts now.

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denny, I tend to defer to this guy:

Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, “adjusted earnings” that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of “restructuring costs” and “stock-based compensation” as expenses.

Charlie and I want managements, in their commentary, to describe unusual items – good or bad – that affect the GAAP numbers. After all, the reason we look at these numbers of the past is to make estimates of the future. But a management that regularly attempts to wave away very real costs by highlighting “adjusted per-share earnings” makes us nervous. That’s because bad behavior is contagious: CEOs who overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be “helpful” as well. Goals like that can lead, for example, to insurers underestimating their loss reserves, a practice that has destroyed many industry participants.

Charlie and I cringe when we hear analysts talk admiringly about managements who always “make the numbers.” In truth, business is too unpredictable for the numbers always to be met. Inevitably, surprises occur. When they do, a CEO whose focus is centered on Wall Street will be tempted to make up the numbers.

Let’s get back to the two favorites of “don’t-count-this” managers, starting with “restructuring.” Berkshire, I would say, has been restructuring from the first day we took over in 1965. Owning only a northern textile business then gave us no other choice. And today a fair amount of restructuring occurs every year at Berkshire. That’s because there are always things that need to change in our hundreds of businesses. Last year, as I mentioned earlier, we spent significant sums getting Duracell in shape for the decades ahead.

We have never, however, singled out restructuring charges and told you to ignore them in estimating our normal earning power. If there were to be some truly major expenses in a single year, I would, of course, mention it in my commentary. Indeed, when there is a total rebasing of a business, such as occurred when Kraft and Heinz merged, it is imperative that for several years the huge one-time costs of rationalizing the combined operations be explained clearly to owners. That’s precisely what the CEO of Kraft Heinz has done, in a manner approved by the company’s directors (who include me). But, to tell owners year after year, “Don’t count this,” when management is simply making business adjustments that are necessary, is misleading. And too many analysts and journalists fall for this baloney.

To say “stock-based compensation” is not an expense is even more cavalier. CEOs who go down that road are, in effect, saying to shareholders, “If you pay me a bundle in options or restricted stock, don’t worry about its effect on earnings. I’ll ‘adjust’ it away.”

To explore this maneuver further, join me for a moment in a visit to a make-believe accounting laboratory whose sole mission is to juice Berkshire’s reported earnings. Imaginative technicians await us, eager to show their stuff.

Listen carefully while I tell these enablers that stock-based compensation usually comprises at least 20% of total compensation for the top three or four executives at most large companies. Pay attention, too, as I explain that Berkshire has several hundred such executives at its subsidiaries and pays them similar amounts, but uses only cash to do so. I further confess that, lacking imagination, I have counted all of these payments to Berkshire’s executives as an expense.

My accounting minions suppress a giggle and immediately point out that 20% of what is paid these Berkshire managers is tantamount to “cash paid in lieu of stock-based compensation” and is therefore not a “true” expense. So – presto! – Berkshire, too, can have “adjusted” earnings.

Back to reality: If CEOs want to leave out stock-based compensation in reporting earnings, they should be required to affirm to their owners one of two propositions: why items of value used to pay employees are not a cost or why a payroll cost should be excluded when calculating earnings.

During the accounting nonsense that flourished during the 1960s, the story was told of a CEO who, as his company revved up to go public, asked prospective auditors, “What is two plus two?” The answer that won the assignment, of course, was, “What number do you have in mind?”

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p.s.

to be clear, and my last post on this, I don’t think the shareholder comp discussion even matters to SHOP (at this point, and it won’t matter for a long while if they do 70% revenue growth), and I think they were incredibly smart to do the secondaries like they did to make that BS absolutely bullet-proof. That is clearly a smart and capable management team…

just make money

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<<<Hi Tinker, perhaps Arista pays the same amount of SBC as Shopify does, dollars-wise, to each hire, but it looks like much less because they have a larger market cap, two and a half times more revenue, etc, so it’s less as a percent of revenue, and it’s less dilution. I don’t know that for a fact, it’s just a speculation…>>>

I will look into it later tonight with more detail. But I think this is not the case. Arista is not buying back any shares that I know of, so any dilution reflects printing shares (such as giving stock options).

The whole numbers are accurate, but the decimal places I forget off the top of my head. Arista had 79 million shares outstanding at the end of this quarter. Forecast is that Arista will have 80 million shares outstanding at the end of next quarter. A better way to look will be an entire year so I will look at that tonight, but if I recall, I think they had 77 to 78 million shares as of Q1 of this year (from some calculation I did in Q2 while comparing it to Nutanix).

It is baffling to me how they do this. Sure, they may pay higher wages (and they can afford it given that they are now creating $200 million per quarter in true free cash flow), but I have no information on this, but they do attract and keep the best talent.

Is an interesting area to dig into. I do not have any historical information as to how this might impact long-term shareholder appreciation.

Do stocks that use lots of stock compensation obtain higher multiples than those that do not?

As Denny says, stock options are clearly an expense to the shareholders, but stock options also - and I believe this is accurate - artificially enhance profitability if you do not count it as a per share number, as you may have less salary expense (I believe Bert mentioned something like this before in an ANET article).

I don’t really know what to make of it other than less dilution is better than more for shareholders, unless the dilution leads to growth that exceeds the cost to shareholders of the dilution. A calculation that appears to never be made.

But companies like Arista or Nvidia can spoil us to thinking that rampant stock options may not be as necessary as we think.

Tinker

denny, I tend to defer to this guy:

I suppose it’s Buffett, he talks so much about Charlie.

It does not change the fact that expensing stock options is atrocious accounting. Whether you like or hate stock options expensing them is not the right way to do it.

Denny Schlesinger

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RE: Putnid

Putnid, I value you what you say in your post greatly, and your posts in general. However I think SBC should be used in precisely the situation where a business is operating at a loss so they don’t burn through their cash. I think the better question is if they are using the SBC to hire and retain the appropriate talent so they are growing and executing well. In this case I would say yes they are.

Best,
Ethan

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Like you Saul, I do not complain about dilutive compensation unless it is excessive. But suppose your ‘That’s life’ was not so and stock options were abolished. Then, I suggest, those ‘rapidly growing young tech. companies’ would soon find they were able to pay bonuses instead. If the level of debt went up as a % of cap. it would speak for itself. You could write the bonus terms into the contracts of employment.

It would overcome the problem of the owners of the companies being diluted with an uncomfortable - or attractive, depending on which side of the fence you were on - level of easy visibility to the owners. I think I am with Buffett on this one. Like a GE jet, it’s currently not quite as transparent as it should be!

It would overcome the problem of the owners of the companies being diluted with an uncomfortable - or attractive, depending on which side of the fence you were on - level of easy visibility to the owners. I think I am with Buffett on this one.

I favor choice over repression. I vote with my wallet, if SBC is abused I don’t buy the stock. But I don’t force people to behave like I want them to. Buffett has an ax to grind and grind he does.

Denny Schlesinger

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Thanks for the kind words, Ethan.

I’ve pretty much stayed out of the fray regarding stock-based compensation. In general, though, I’m no fan of excessive compensation. I consider it a warning sign that the management is focused more on their personal wealth than on shareholder wealth. Obviously, there’s lots of room for debate. Here’s an article you may find interesting:

https://www.investors.com/news/technology/amazon-stops-prete…

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I’m no fan of excessive compensation. I consider it a warning sign that the management is focused more on their personal wealth than on shareholder wealth.

Hi putrid,

I know you are angry at stock based compensation, but it doesn’t go to senior management in most tech companies, after what they get in the IPO. It’s how the company lures new bright young prospects to come work for them (as I understand it).

Saul