mYCharts - November 4, 2021
Stock-based Compensation: A Love/Hate Relationship with Simon Erickson
In today’s full-throttle world, we’ve gone numb to hearing about stock-based compensation.
During earnings calls, we yawn or mentally check out when companies start talking about their “adjusted earnings” or their “adjusted margins”. We already know and have come to accept that Silicon Valley’s fast-growing tech companies are handing out generous stock plans as a way to retain their talented software developers. And because stock is characterized as a non-cash expense, those “adjusted” figures can just stay in the green and keep expanding over time.
After all, stock is just a nice alternative to avoid paying higher and higher cash salaries. And that’s a win for long-term investors too…right?
Unfortunately, there truly is no such thing as a free lunch. Stock-based compensation might be generally-accepted, but it certainly comes at a cost.
Companies do indeed reduce their upfront expenses when they pay bonuses in stock rather than in cash. But this also causes them to dilute their shareholders later on.
And for long-term investors like us, that could be a red flag that is worth keeping an eye on.
To see why, let’s look at an article that Barron’s published one year ago. It red-flagged those large-cap companies who were paying the highest percentage of revenue as stock-based compensation.
The top three offenders on this list were Snapchat $SNAP, Uber Technologies $UBER, and Snowflake $SNOW. Snapchat took the honors as the most generous payer — shelling out a full 40% of annual revenue at stock compensation!
Download Visual l Source: Barron’s
So let’s get to why this matters. Diluting investors by issuing stock-based compensation is like cutting a pizza. Each additional cut gives every person a smaller and smaller slice. And I’m pretty sure I speak for everyone when I say that none of us wants less pizza.
A company’s market capitalization is the numerical value of the entire pizza: the price per share multiplied by the total number of shares outstanding. Though as individual investors, we’re much more interested in that price per share — because that’s what directly impacts how much money we’re making or losing on our investment. If a company’s market cap stays exactly the same but it doubles its share count, each of our shares would be worth half as much as before.
So this eventually turns into a problem. Those stock awards can really add up over time, and this can become death-by-a-thousand papercuts for long-term investors.
To illustrate using YCharts, I’ve created two graphs for each of these three serial-stock-awarders since they hit the public markets in their IPO. The first graph shows the company’s average diluted share count, displayed in absolute terms. This is the total number of slices the pizza is cut into. The second graph shows the change in the company’s market capitalization (the size of the whole pizza), but as compared to the price per share (the size of each individual slice). These are displayed as a percentage change, since the date of their IPO.
Let’s dig in (now I’m getting hungry).
Snap, Inc (NYSE: $SNAP): IPO on March 2, 2017
Even after its public offering, the social networking camera company’s egregious stock bonuses have snapped its outstanding share count up by 25% during the past four years.
As a result of those bonuses, its per-share returns are lagging its market cap expansion by 85 percentage points after just four years.
Uber Technologies (NYSE: $UBER): IPO on May 10, 2019
The popular ride-sharing app has certainly been issuing an uber amount of stock. Its outstanding share count is rapidly approaching 2 billion.
That’s been putting the brakes on investor returns. Its per-share price is only up 12% in the two and a half years since its IPO.
Snowflake (NYSE: $SNOW): IPO on September 16, 2020
The chilly-sounding data warehouse provider has been warming up to issuing stock to its leadership team, and that’s been rapidly expanding its outstanding share count.
But winter may be coming for long-term investors. In the year since Snowflake’s IPO, per-share returns are already lagging the growth in market cap by 12 percentage points.
If you remember just one thing from this mYCharts blog post today, let it be this: Stock-based compensation is not free.
Even the sexiest, fastest-growing tech companies who are attracting the brightest minds and are aggressively gaining share on their competitors still need to be diligent and responsible when it comes to managing their expenses.
And if you’re a long-term investor who’s interested in long-term returns, your future self will thank you for being a little less numb to what’s really behind the curtain of those “adjusted earnings”.
Simon Erickson is the founder and CEO of 7investing. He is one of the stock market’s most forward-looking investors, focused on identifying disruptive innovation and finding developing trends before others may even be aware of them.
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