Cantor Fitzgerald, a preeminent capital markets investment bank, warned investors and traders alike that exaggerated use of stock-based compensation (SBC), a commonly used way to compensate employees may actually be detrimental to the growth of companies in the long run.
This is due to the possible misinterpretations in the non-GAAP financial measures of companies providing excessive SBC. Non-GAAP metrics provide an increased insight into the business however, distortions due to high SBC ratio may affect valuation multiples and financial margins which can ultimately result in the dilution of outstanding shares over time for the company. Some firms tend to view high SBC payout ratios as a real expense in the long run. As such, investors should pay more attention to non-GAAP measures.
Stock incentives given to employees are typically done by startups or companies at the start of their hyper growth phase and offering a tender initial public offering (IPO). This is mainly due to the startups not having enough cash on hand to account for their expenses concerning employees. With these methods, the heads and staff can ride on the company’s growth and revenue increases. However, there are a lot of restrictions and laws that impose tax, registration issues, and additional expense charges for SBC payouts.
Furthermore, while even the most recent Securities and Exchange Commission’s (SEC) guidelines on non-GAAP metrics published this year do not deal with SBC issues directly, it still seems that some firms are targeting stricter qualities on non-GAAP disclosures.
Youssef Squali, an analyst of Cantor Fitzgerald, noted that the worst culprits of SBC’s use, (with the highest effect on individual price targets quantified per-share) are Twitter Inc (NYSE:TWTR), and Amazon.com, Inc. (NASDAQ:AMZN), Inc.
SBC’s are widely used by Twitter, Yahoo! Inc. (NASDAQ:YHOO) and Yelp Inc (NYSE:YELP) with the tax deductible incentives amounting to 92%, 66% and 78% respectively for fiscal year 2016 (FY16) earnings before interest, taxes, depreciation, and amortization (EBITDA) forecasts. However, SBC’s are not recommended for companies already in full bloom or in their late stages of growth. Among the companies with the top SBC payout ratio, only Twitter is a comparably-new IPO. However, the positive revenue growth and profits of Twitter are already slowing down at a considerable amount.
Squali also noted that investors typically indulge with higher SBC payout ratios as long as the company is followed up by high growth and increase in revenues. With the difficulty of analyzing all the variables pertaining to the impact of SBC’s on the stock price performance, Squali insists that high stock incentives, coupled with a decelerating revenue growth and slumping margins are detrimental to the stock price performance.
However, the significance of SBC as an incentive should not be overlooked, and it should slow down when coupled with the expansion of businesses. Squali points out that investors should look for companies that have an optimal use of SBC which is suitable for long-term growth which will translate to profits for shareholders.
The analysts also mentioned that Twitter Inc. and Amazon.com, Inc might squander a compelling amount of their target prices, amounting to 30.2% and 22.6%, respectively, if the effect of SBC is taken into account. The adjusted price targets would be $13 and $646, which translate to a 31.6% and 15.5% downside concerning the current stock prices.