The gains in this year’s US stock market are hard to appreciate. Only seven stocks are responsible for the advance in the S&P 500 so far. Additionally, there are concerns about the quality of companies’ earnings, as profit growth is not supported by an increase in cash flow.
However, there is some good news when it comes to tech stocks. They don’t appear to be overpriced, as long as you ignore the issue of cash, and if you exclude certain costs from earnings calculations. Morgan Stanley’s tax, valuation, and accounting team, led by Todd Castagno, recently examined earnings quality. This is important because companies tend to manipulate adjusted earnings to meet expectations, especially during a turning economy.
The team found a widening gap between earnings calculated using US regulatory accounting standards (GAAP) and companies’ preferred methods of reporting profits (non-GAAP earnings). It’s worth noting that non-GAAP earnings are not inherently bad or unhelpful, especially for investors in publicly traded companies that disclose the reconciliation of their non-GAAP figures. Investors often want to exclude one-time events that obscure a company’s true profitability. However, it becomes less useful when ongoing expenses that significantly impact per-share profitability are waved away, such as stock-based compensation (SBC).
SBC was the largest adjustment for Nasdaq 100 constituents last year, according to the Morgan Stanley analysts. They believe it is a true operating and recurring economic cost that investors should consider in valuation. The prevalence of SBC has grown over the past decade, primarily among tech companies that use stock options to pay employees.
While SBC can be beneficial in an up market, allowing companies to attract and retain talent and enjoy tax deductions, it can become problematic in a down market. Companies start issuing more stock options to make up for employees’ loss of compensation, diluting the value of existing shares. If the market continues to perform well, SBC-heavy companies that become profitable could flood the diluted share count.
To address this issue, the analysts suggest including SBC cost in earnings and treating it as a cash proxy in free cash flow (FCF) based valuations. When using a multiple or discounted cash flow (DCF) model, the value implications of future stock issuance should be adequately captured. Additionally, companies often use share buybacks to offset the dilution from SBC, and investors should compare the amount of stock repurchased to the net SBC cost to assess whether the buyback truly returns capital to investors.
In summary, while the US stock market gains may seem impressive, a closer look reveals concerns about earnings quality and the impact of stock-based compensation. Investors should carefully evaluate SBC and its effects on valuation, incorporating it into earnings calculations and considering the implications for free cash flow and share buybacks.
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