Question About Ubben Interview
http://www.reuters.com/video/2014/04/29/milken-tremendous-upside-in-mic…
With 2:00 left, in response to the "What do you mean by fixing tech?" question, Jeffrey Ubben responds with "We, the market, could or could not capitalize non-cash expense" and "We gave them a pass, and to the tech company, the money looks free, because there's a P/E on their expense." What did his answer mean? If anyone could translate it for me, that'd be great. Thanks in advance.
Short version: Omitting non-cash expense from valuation removes a liability (i.e. negative cash-flow) and so inflates value, which increases price, with no effect on earnings. Therefore omitting non-cash expense inflates price to earnings (effectively recognizing a liability as an asset for free).
Blow by blow translation: "There was a point where we, as the market, possessed the opportunity to establish precedent of whether to include non-cash expense, mostly stock compensation, in valuation of the company. Non-cash expense represents a negative cashflow. Ignore negative cash flow and your present value goes up.
We decided to ignore this value depressing account ("we gave them a pass"). From the tech companies perspective, this makes their book look better ("this is free money") and so the expense-omission valuation is greater than if non-cash was capitalized. Given the outsized value of this liability on a lot of tech company books, this decision to ignore a big liability made a material difference.
Since price is, in theory, a reflection of value, and since value is now materially augmented due to omission of non-cash expense items, prices are also augmented.
But omission of non-cash expense has no bearing on earnings. So value goes up, price goes up, earnings remain the same and so today tech companies are getting added price-earnings ratio, relative to the alternative of capitalizing non-cash expense ("because there's a P/E on their [omitted] expense")."
SB'ed. Thanks a bunch.
Glad to help. I had to listen to it a few times too.
I would be careful about saying they “ignore” stock based compensation (the expense in this case). Rather they are discussing whether or not the cost should be expensed or capitalized. When you capitalize an expense it actual gets put as an asset on the balance sheet that is used to generate future revenue and written off as it is incurred. If you expense this cost instead, it obviously decreases operating income and net income like any other expense. By capitalizing this expense, it does not hit your income (in the current period at least).
What Ubben is saying here is that Tech companies have a tendency to use stock based compensation to pay employees more so than other industries, and they often treat these capitalize these expenses on their balance sheets. This will increase earnings and when you are valuing a company like this on a P/E ratio, you are then applying that P/E on a higher earnings base (EPS being higher by the amount of the expense which is pushed out to a future period). This is essentially “free cash” because by using stock based compensation rather than paying a cash salary to employees that would hit SG&A, the company is avoiding the expense hitting their net income and thus inflating profits. Worldcom and Enron were experts at capitalizing all sorts of expenses. For a more recent tech example see CRM (in my opinion at least, this form of comp becomes recurring when you use it as a regular expense of doing business like they do).
SB'd
You're saying that tech companies are pushing a given period's compensation into the future via stock based compensation and so these companies do not record the value of this compensation as SG&A, which is a negative account on the income statement. As such, this results in higher NI than if they did recognize the value of compensation so it increases earnings. Assuming you are given a P/E ratio, a priori, a greater multiplicand in the earnings would result in a higher expected price in a multiples valuation. Certainly such a tactic is not sustainable and in the long-term its effects should correct (you hinted at this with "in the current period at least").
My confusion then is that P/E is calculated using the (the similarly inflated) earnings of comparitor firms from the same industry as target. If the industry as a whole is inflating earnings, then your P/E based on comps is based on the same inflated earnings (at the comps), and so you decrease the P/E ratio (relative to not capitalizing stock based compensation). Now, when you apply this deflated P/E ratio to the inflated earnings of your target, it is no longer clear how and to what extent tech stocks are overpriced.
Why don't you just adjust your comps to give a fair comparison?
If you want to use a lower P/E ratio to value tech companies that do this, then that is fine. Most good investors do not simply take earnings and apply an average multiple on them anyways, typically more goes into it than that. A more accurate way than lowering the multiple by some amount would be to simply adjust their financials to take into account the stock compensation as an expense if that is what you believe.
Ubben is saying that the market as a whole is taking these tech companies at their word that this stock based compensation should be capitalized and that this is the proper way to treat it. Whether you as an individual investor believe that is up to you. As I mentioned above there are lots of examples of companies like Worldcom and Enron that did this with other line items. You as an individual can do whatever you want when valuing a company (use a lower P/E on tech companies, adjust earnings for one time items and expenses, write off bad assets), but how the market as a whole values a company in the short term may be completely different.
So basically right now the market is giving tech companies a pass on capitalizing these assets. In the future there may be a point where compensation is outweighing revenue growth in these momentum tech names and that is when the music stops so to say. Or their revenue growth could outpace comp and they eventually transition into a more typical compensation profile as they mature. That's what investors try to figure out.
This doesn't change the answer you guys get to but he doesn't mean capitalize in the way that your accounting class does (i.e. put it on the balance sheet and depreciate it) - there's no asset on the balance sheet for stock comp. GAAP requires stock comp to be expensed (fasb 123) but this doesn't stop every tech company from adding back stock comp to get to an "adjusted eps". See any new tech company's earnings release for this. Many will even break out the stock comp by line item for you.
Ubben is saying they're able to do this BC investors and analysts accept it and apply a p/e ratio on this fake earnings. While a creditor might not care about this non-cash expense (as long as the stock price is high and your employees will still accept stock as pay) equity holders certainly should - it's paid out of their ownership stake! It's also a big issue for employee retention when your stock price goes down.
This is what makes the payout structure ValueAct came up with at VRX so smart - Pearson has become a billionaire but he only gets his options if the stock price compounds at a very high level. When this happens equity holders are happy to get diluted, his incentives are perfectly correlated to long-term stock value.
Correct, I should have clarified I was talking about reported non-GAAP EPS as this is what the general market will often value a company off of and look to during earnings (in my opinion incorrectly). This is the main driver of many tech companies reporting profitability on a non-GAAP basis, while GAAP earnings remain firmly in the red.
I don't think investors give tech firms a pass on their treatment of stock based comp (or intangible amortization for that matter)
Non-GAAP multiples can look cheap but the "market" does a reasonable job of reflecting stock compensation dilution in the stock price. (Running a consensus DCF that treats stock comp as an expense tends to align with the stock price.)
Many (albeit more mature) tech companies include stock based comp in their non-gaap numbers.
There has been a clear trend in aligning stock based comp with shareholder interests by tying vesting schedules to returns based metrics (i.e. ROIC and Total Shareholder Returns). There's a lot more that can be done but things have improved tremendously over the past 3 proxy seasons.
Good to hear from you Mr Pink Money
Ditto. Back from the dead?
Your old posts helped me advance my career tremendously - never got to thank you, Mr Pink.
Same
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