Are Stock Market Gains in the US Cause for Celebration?
Introduction:
The US stock market has experienced gains this year, but finding reasons to appreciate these gains may be a challenge. With only a handful of shares responsible for the year-to-date progress of the S&P 500, there are concerns about the quality of corporate earnings and the sustainability of profit growth. Additionally, there are questions about the accuracy and transparency of non-GAAP earnings reporting. In this article, we will explore these issues and delve deeper into the impact of stock-based compensation on companies and investors.
1. Limited Contribution of Shares to Market Gains:
The first issue to consider is the limited number of shares that are driving the gains in the US stock market this year. According to reports, only seven shares are responsible for the year-to-date progress of the S&P 500. This raises concerns about the market’s reliance on a small number of companies for growth and the potential risks associated with such concentration.
2. Deterioration in Corporate Earnings Quality:
Another reason to be cautious about the current stock market gains is the signs of deterioration in the quality of corporate earnings. While profit growth may appear positive on the surface, it is not always supported by a corresponding increase in cash flow. This raises doubts about the sustainability of earnings growth and the underlying health of companies.
3. Non-GAAP Earnings Reporting:
A significant factor contributing to the questionable quality of corporate earnings is the use of non-GAAP earnings reporting. Non-GAAP earnings refer to metrics that companies prefer to use for reporting profit or earnings, which may differ from the standard accounting principles known as generally accepted accounting principles (GAAP). While non-GAAP earnings can provide insights into a company’s underlying profitability by excluding one-time events, they can also be misleading when companies waive ongoing expenses that significantly impact profitability per share.
4. Stock-Based Compensation (SBC):
One of the key expenses that companies often waive when reporting non-GAAP earnings is stock-based compensation (SBC). SBC refers to the practice of providing stock options to employees as part of their compensation. While this can be advantageous in a bull market, allowing companies to attract and retain talent without substantial cash outflows, it can have negative consequences during a downturn. When markets decline, companies may issue more stock options to compensate for the loss of salary, resulting in further dilution of existing shareholders’ holdings.
5. Impact of SBC on Share Count and Dilution:
The widespread use of stock-based compensation, particularly in the tech sector, has led to a significant increase in the number of outstanding shares for many companies. This dilutes the ownership value of existing shareholders and can have a negative impact on a company’s stock price. Moreover, anti-dilution measures can mask the true extent of dilution in reported earnings, further obscuring the picture for investors.
6. Valuation Challenges and Adjustments:
The presence of stock-based compensation poses challenges for investors when valuing companies. Traditional valuation methods may not adequately capture the impact of SBC on a company’s financials. Investors are advised to treat SBC expenses as a cash proxy, reducing free cash flow in free cash flow (FCF)-based valuations. Additionally, when comparing companies for potential investments, growth rates should be adjusted for dilution rates to account for the impact of SBC on future earnings.
7. Share Buybacks and Dilution Offset:
In an effort to mitigate the dilutive effects of stock-based compensation, companies often use share buybacks. However, it is important for investors to assess whether the amount of stock repurchased truly offsets the net cost of SBC. Comparing the repurchased stock against the SBC net cost can provide insights into whether a company is genuinely returning capital to investors or simply offsetting the dilution caused by stock compensation.
Additional piece:
The use of stock-based compensation has become increasingly prevalent in the tech industry, where companies rely on stock options to attract and retain talent. While this practice can provide benefits in a bull market, it also exposes companies to risk when markets decline. The current stock market gains in the US have masked the potential consequences of this widespread use of SBC. However, as interest rates rise and funding becomes scarce, the negative consequences of stock-based compensation may become more apparent.
Investors should exercise caution and consider the impact of stock-based compensation on a company’s financials and valuation. This requires a thorough assessment of the dilutive effects of SBC on earnings per share and the potential for further stock option issuance. By accurately accounting for these factors, investors can make informed decisions and avoid overvaluing companies that rely heavily on stock-based compensation.
Conclusion:
While the US stock market has experienced gains this year, there are reasons to be cautious about these developments. The limited contribution of a small number of shares to market gains and the deterioration in the quality of corporate earnings raise concerns about the sustainability of the current upward trend. The use of non-GAAP earnings reporting, particularly in relation to stock-based compensation, further complicates the picture for investors. By understanding and accounting for the impact of stock-based compensation on a company’s financials and valuation, investors can make more informed decisions and navigate the complexities of the current stock market climate.
Summary:
The US stock market has seen gains this year, but the limited contribution of a few shares to these gains raises concerns. Additionally, the quality of corporate earnings has deteriorated, with profit growth not supported by an increase in cash flow. Non-GAAP earnings reporting, including the exclusion of ongoing expenses such as stock-based compensation, further complicates the picture. The widespread use of stock-based compensation, particularly in the tech sector, has led to dilution and potential risks. Investors are advised to adjust valuations and consider the impact of stock-based compensation on a company’s financials. Share buybacks may offset dilution but should be carefully assessed. Overall, caution is recommended in interpreting market gains and understanding the implications of stock-based compensation.
—————————————————-
| Article | Link |
|---|---|
| UK Artful Impressions | Premiere Etsy Store |
| Sponsored Content | View |
| 90’s Rock Band Review | View |
| Ted Lasso’s MacBook Guide | View |
| Nature’s Secret to More Energy | View |
| Ancient Recipe for Weight Loss | View |
| MacBook Air i3 vs i5 | View |
| You Need a VPN in 2023 – Liberty Shield | View |
It’s hard to find reasons to appreciate this year’s US stock market gains.
Only seven (7) shares they are responsible for the year-to-date progress of the S&P 500, for one thing. And there are signs of deterioration in the quality of corporate earningsas profit growth is not supported by a corresponding increase in cash flow.
The good news is that tech stocks don’t look all that expensive, as long as you ignore that pesky liquidity problem and exclude a growing percentage of costs from corporate earnings.
Morgan Stanley’s tax, valuation and accounting team, led by Todd Castagno, got another look at earnings quality this week. That’s important because with “the pressure to meet expectations in a turning economy, companies tend to stretch adjusted core earnings relative to reported earnings,” they say.
They find that the spread has widened between 1) metrics that meet US regulatory accounting standards, known as generally accepted accounting principles, or GAAP; AND 2) companies’ preferred methods for reporting non-GAAP profit or earnings. From the bank:
To be clear, non-GAAP earnings aren’t necessarily bad or worthless, at least to investors in publicly traded companies, who are required to publish a reconciliation of their non-GAAP figures against GAAP standards. And investors often want to rule out one-time events that obscure a company’s underlying profitability.
But the practice becomes less useful when companies begin to waive ongoing expenses that significantly impact profitability per share. Such as stock-based compensation, also known as SBC.
SBC is responsible for most of last year’s disparity between adjusted earnings and GAAP earnings, Morgan Stanley analysts found:
They continue:
. . . stock-based compensation is the largest adjustment for Nasdaq 100 constituents. We believe SBC is a true operating and recurring economic cost that investors should consider when evaluating. The extent and prevalence of BCS have grown over the past decade.
This illustration of SBC spending since 2010, in a separate June 16 memo from the same team, well illustrates the growing importance of SBC to Russell 3000 companies:
Not cumulative (see SoftBank slides)
US companies have only been required to report SBC as an expense since 2006, like Michael Mauboussin underlined in April. And lest readers think this is just a problem for season by proxynearly 80% of stock-based compensation is “paid to employees who are not high-ranking executives”.
This is mostly true of tech companies, it seems. They’ve relied more heavily on stock options to pay workers over the past decade, offsetting small declines in SBCs in other industries and a large decline in SBCs for workers in the financial sector. From Morgan Stanley’s June 16 memo:
This can be good for both workers and companies when stonk lines go up – the company stays more liquid and its employees get some of the upside and more skin in the game.
But when the markets go the wrong way – interest rates go up, VC funding runs out, etc. – this virtuous circle can turn into a vicious circle quite quickly. As the bank’s analysts put it:
SBC is a great tool in an upscale market as it allows companies without much disposable cash to pay competitive rates of total compensation to attract and retain talent, better align shareholder and employee interests and morale, and enjoy greater tax deductions. However, in a bear market, the opposite is true, creating a negative feedback loop.
Companies start issuing Moreover stock options to compensate for the loss of salary of its employees. This further dilutes the company’s other existing shareholders, further reducing the value of a share (for those without holdings and anti-dilution options). This is especially true if tech stocks rally further and put other employee stock options back in the money.
From Morgan Stanley:
The market’s -19% total return in 2022 has swamped many of the SBC premiums issued (based on grant date valuations and option strike prices) and we have seen many companies “top up” employees with additional grants to compensate for paper losses. Additionally, many of these premiums may not appear in the diluted share count if anti-dilution, supporting EPS. If the market holds current levels or stretches further and SBC’s heavyweight companies turn profitable, a stock surge could hit diluted stock tallies.
Some of the biggest possible offenders — which had the biggest increases in grant amounts from 2021 to 2022 — include Zoom, Pinterest and DocuSign, MS says. Find the full list here. (Some of these companies have made deals that could have affected SBC. The list includes AMD, for example, which had a mega deal to buy Xilinx last year.)
Suppose investors simply decide to use GAAP earnings to calculate a company’s EPS. Does this solve the problem? Analysts say not. They believe investors should still take into account the EPS dilutive effects of share-based remuneration:
Is this a double count? A common valuation criticism against our philosophy is that spending SBC plus penalizing a company for EPS dilution is double counting and overly burdensome. We disagree as we believe that we need to separate and account for (1) awards that have already been granted and (2) awards that are expected to be granted in the future. The awards already granted should be charged to the outstanding diluted shares (denominator) and the foreseen future grants are real economic and operational costs and should be charged to the numerator.
So what’s a fund manager, Reddit day trader, or any type of non-employee shareholder to do?
Our preferred approach to incorporate SBC into valuations is to include cost in earnings and treat SBC expenses as a cash proxy (reducing FCF) in FCF-based valuations. When using a multiple or DCF model, we should adequately capture the value implications of future issuance, however many investors are heavily focused on FCF margins and growth, causing some consternation.
A company diluting equity with SBC at 3.0% per annum does not deserve the same multiple and valuation as another company diluting at 0.5% per annum, all other things being equal. When performing a comp analysis, growth should be adjusted for dilution rates. . .
Companies often use their share buyback authorizations to offset dilution from SBC. We suggest comparing the amount of any stock repurchased in a period against the SBC net cost to see whether a repurchase is actually returning capital to investors or simply offsetting the dilution of stock compensation.
Further reading:
— The hidden leverage of stock-based remuneration (FTAV)
— The kings of cloud software are crazy, when is the crash? (FTAV)
— Free cash to whom? (FTAV)
https://www.ft.com/content/9abdcf72-98db-4870-a7d5-f4173b5e9c2a
—————————————————-