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Alibaba joins Facebook, others downplaying cost of employee-stock grants

·Michael Santoli

When Alibaba Group (BABA) delivered its first quarterly report as a public company Tuesday, the headlines flashed per-share earnings of $1.1 billion, or 45 cents a share, up 15% from a year earlier and right in line with the consensus of Wall Street’s enthusiastic analyst corps.

Yet these upbeat numbers excluded some $490 million in expenses from Alibaba stock given to employees as part of their compensation. This stock-based compensation expense made up the vast bulk of items excluded from Alibaba’s preferred “adjusted” profit measure.

The Chinese ecommerce giant’s profit based on standard accounting principles was $494 million, or 20 cents per share, less than half the figure featured and celebrated.

In this way, Alibaba fits right in with its American peers among Internet companies, which promote adjusted earnings measures excluding equity compensation costs to flatter their results in a way that companies in most other industries don’t even attempt.

As the nearby graphic of the past four quarters’ stock-based comp adjustments shows, the amounts that some leading tech companies try to set aside from “core” earnings with the tacit approval of analysts and professional investors are hardly trivial. Google Inc. (GOOGL, GOOG), Facebook Inc. (FB) and Twitter Inc. (TWTR) together have incurred a combined $6 billion in stock-based comp expense over the past 12 months that they add back to produce preferred “non-GAAP earnings.”

In the most conspicuous cases, the discrepancy is the difference between investors persuading themselves they are paying a yawning premium and merely a healthy premium, as I discuss in the attached video with Yahoo FInance host Jen Rogers. Thus Facebook’s trailing price-to-earnings ratio goes from 48 to nearly 70.

On a market-wide basis, this collective agreement to permit certain companies to adopt a more flattering version of their results lends a slight but meaningful upward bias to the aggregate profit forecasts that many market bulls use to say stocks are attractively valued.

Back to the ‘90s

The exclusion of equity-compensation expense for cosmetic purposes is rooted in the tech boom and bust of the late ‘90s and early 2000s. During that bubble, accounting rules allowed companies to ignore stock-option grants under the most common circumstances, which led to their being handed out willy-nilly as if they were free money.

By 2006, authorities decided that generally accepted accounting principles would force companies to deduct options expense. This led many companies to turn to restricted-stock grants, and others to carve this expense out to minimize the apparent hit to profits and maintain comparability with prior years’ results.

There have been two main explanations offered by those who believe it makes sense, or at least is not a problem, to exclude stock-compensation expense.

The first excuse, which was more common in the ‘90s, holds that equity comp is not a true expense of the company, given that it isn’t a cash cost.

This idea is mostly discredited. Many expenses, such as depreciation, aren’t ongoing uses of cash but must be deducted from revenue to arrive at profit. And stock-based comp hands small pieces of the company to employees, which spread the cash profits and (for some companies) dividends across more owners.

Aswath Damodaran, professor at New York University Stern School of Business and an expert in equity valuation, nicely dismantled the idea that equity comp is not an expense in this February blog post, which uses Twitter as a case study.

Warren Buffett’s famous quip on employee stock options also applies to all stock-based pay: “If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And if expenses should not go into the calculation of earnings, where in the world should they go?”

This is a more crucial issue today in Silicon Valley, because the use of company stock as a standard form of compensation in lieu of cash – rather than incentive bonuses for the upper tier – has become so deeply ingrained.

Not long after Facebook’s 2012 IPO, founder and CEO Mark Zuckerberg admitted in an interview that he uses stock as a straight replacement for cash: “The way we do compensation is we translate the amount of cash we give you into shares…. So if the stock is undervalued you’re going to get more shares.”

This mode of pay also becomes an indirect cash cost when companies seek to fight the dilution that comes with heavy stock issuance to employees through share buybacks.

Can’t the market just sort it out?

The other argument for looking past stock-based pay is that the market most cares about how fast young, promising companies are growing, and that over time the drag from equity grants shrink to become trivial for the long-term investor.

Indeed, while Google still has a big, ongoing drag on GAAP earnings from large stock grants, any investor who got caught up in this issue and avoided the stock missed perhaps the greatest investment of the past decade.

(It should be noted that Yahoo Inc. (YHOO), parent of Yahoo Finance, continues to incur substantial stock-based compensation that it excludes from “adjusted earnings” figures even as its core business has matured.)

But for every Google, there are dozens of upstart tech companies that ladle out shares to employees and never reach escape velocity on growth.

Shouldn’t the market easily sniff out the true underlying economics of a business, regardless of how numbers are massaged in press releases and investor presentations? Over time, this absolutely occurs.

And, of course, many alternative ways of evaluating companies aside from the rigid and sometimes arbitrary GAAP numbers thrive. Cash-flow trends arguably say far more about many companies’ strength than the all-in per-share earnings results do, for instance.

Yet if the highlighted, massaged earnings benchmarks don’t fool or sway the market in the near term, then why would companies go to the trouble of using them? And, to return to the primary question, why do analysts and investors happily oblige?