Equity-Based Compensation: Are Non-GAAP Earnings Misleading?

During the 1990s debate over the status of stock options as a corporate expense, the big technology companies argued passionately that, since stock option grants to employees don’t ding the corporate checkbook, they should not be recognized as an expense. Despite winning the initial battle (SFAS 123), the tech companies ultimately lost the war (SFAS 123R).

As noted in this article by Tim Shufelt, many big-name tech companies include, as a non-GAAP measure of financial performance, earnings exclusive of the despised stock-based compensation charge. Not surprisingly, earnings without the options-related charges are considerably more robust for highfliers like Amazon and Netflix. For example, in its investor slide deck for the Q3, 2013 earnings call, Amazon touts a non-GAAP earnings measure called “Consolidated Segment Operating Income” or “CSOI”. The principal reconciling item between CSOI and GAAP Operating Income is stock-based compensation. For the twelve months ended September 30, 2012, CSOI was $1.795 billion, or 2.8x GAAP operating income of $640 million.

Amazon’s 10-Q for the quarter ended September 30, 2013 offers the following justification for excluding stock-based compensation from measures like CSOI:

“Operating expenses with and without stock-based compensation is provided to show the impact of stock-based compensation, which is non-cash and excluded from our internal operating plans and measurement of financial performance (although we consider the dilutive impact to our shareholders when awarding stock-based compensation and value such awards accordingly). In addition, unlike other centrally-incurred operating costs, stock-based compensation is not allocated to segment results and therefore excluding it from operating expense is consistent with our segment presentation in our footnotes to the consolidated financial statements.”

The 10-Q does acknowledge the drawbacks of excluding stock-based compensation from earnings, effectively summarizing the prevailing rationale for including such compensation as an expense:

“Operating expenses without stock-based compensation has limitations since it does not include all expenses primarily related to our workforce. More specifically, if we did not pay out a portion of our compensation in the form of stock-based compensation, our cash salary expenses included in the ‘Fulfillment,’ ‘Marketing,’ ‘Technology and content,’ and ‘General and administrative’ line items would be higher.

From a valuation standpoint, it is noteworthy that the rationale for the adjustment is supported, not by the expectation that such grants are unusual or non-recurring, but rather by the fact that the grants do not immediately consume corporate cash. However, as acknowledged by Amazon, cash is preserved only at the expense of shareholder dilution, a very real albeit “soft” cost.

Regardless of the ongoing debate about how best to measure earnings, stock-based compensation is a tool used by companies of all sizes and in all industries. In order to deliver the most reliable information to investors, companies need to carefully evaluate the value of such compensation packages when granted. Mercer Capital’s senior professionals have deep experience helping clients measure the fair value of stock-based compensation for accounting and tax purposes; give us a call, we’d like to help.