Tech-sector profitability comes with an asterisk.
It’s now common practice at fast-growing companies like Amazon.com, LinkedIn, Facebook and Google to present alongside standard earnings a modified figure that excludes stock-based compensation expenses.
This measure, according to critics, can inflate investors’ impression of a company’s profitability and understate the level of risk attached to certain stocks.
To be sure, there is nothing illegal about the way high-tech earnings are reported. As required by accounting standards in both Canada and the United States, the cost of rewarding employees with various kinds of stock awards appears on the income statement.
The issue is the growing habit of adding an alternative measurement – usually referred to as adjusted earnings – in which those and other costs are added back. The result? An apparently higher level of profitability.
Companies are “not manipulating the financial statements, they’re trying to manipulate the perception of investors,” said Ramy Elitzur, a professor at the University of Toronto’s Rotman School of Management.
Adjusted earnings take Amazon’s estimated price-to-earnings ratio from about 455 all the way down to 151. While LinkedIn’s P/E based on its earnings under generally accepted accounting principles (GAAP) is 1,103, its P/E ratio using adjusted profits shrinks to 138. Salesforce.com goes from a loss to a profit.
And it’s that rosier take that is offered up by many tech enthusiasts as the more faithful representation of earning capacity. For the most part, investors and analysts happily oblige them.
“It’s hard to say if [the companies] are the ones doing the encouragement or whether it’s just become a convention,” said Brian Wieser, senior research analyst at Pivotal Research Group in New York.
Either way, “it’s a back-door way of getting to the way things used to be,” said Darren Henderson, an accounting professor at the Richard Ivey School of Business at the University of Western Ontario.
Stock options were a key element of employee compensation at many tech companies during the dot-com boom. They were used to attract executive talent and – in theory – to align executives’ incentives with shareholder interests. Since they did not involve the outlay of cash, they were kept off the income statement.
Nobody cared, so long as tech stocks were rising. But with the bursting of the tech bubble, the accounting treatment of options came into disrepute. “I fear that the failure to expense stock option grants has introduced a significant distortion in reported earnings,” Alan Greenspan, then chairman of the Federal Reserve, said in 2002.
It was “critically important,” he said, that stock options should be treated the same as other forms of compensation. The tech giants protested. They argued that since stock options are non-cash items, they should not be considered expenses. That argument failed to prevent accounting changes in 2006 that forced U.S. companies to expense stock-based compensation. But the debate simmers on.
“When [a stock option] never requires a cash outflow, how can it be considered an expense of the firm?” said Mr. Henderson, who sides with the tech companies on this matter. “I think the modified measure gives a better idea of the cash-generating ability of the firm.”
The accounting establishment mostly disagrees. If not for stock awards, companies would have to pay higher salaries, Mr. Elitzur argues. “You’re utilizing resources in order to generate income. That makes it the equivalent of salaries.”
Over the past few years, tech firms have moved away from stock options in favour of restricted stock, which vests over a defined period. But many firms still argue the cost of stock-based compensation doesn’t necessarily affect profitability.
“Stock-based compensation … is non-cash and excluded from our internal operating plans and measurement of financial performance,” Amazon said in its 2012 annual report. Facebook supplements its GAAP reporting because it says excluding the expense “provides investors and management with greater visibility to the underlying performance of our business operations.”
Of course, concerns that adjusted earnings may be overstating the current picture are less of an issue when investors are buying stocks for their supposed ability to grow future earnings by enormous amounts.
“Any investor looking at a company like Twitter solely on the basis of what its profits are today should probably be staying away from that stock,” Mr. Wieser said. “It’s just not relevant.”
His chief concern is for investors who might place too much importance on a single earnings figure.
Investors’ impressions can be swayed by tech companies proclaiming the superiority of adjusted earnings, said Barry Schwartz, vice-president of Baskin Financial Services.
“It’s just one snapshot of the health of a company, and a lot of these companies are not as healthy as you think they are.”
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