We see companies do stupid things all the time that erodes shareholder value. Here are three of them that really irk me.
Targeting stock-based compensation as a percent of revenue
Many companies don’t seem to understand stock-based compensation.
Twilio is one such example. In an investor presentation last year, Twilio mentioned that it was targeting to reduce stock-based compensation as a percent of revenue.
Stock-based compensation on the income statement is recorded based on the share price at the time of grant. Using a percent of revenue as a stock-based compensation measure just shows how little management understands it.
Stock-based compensation on the income statement can drop simply because share prices have fallen. So lower stock-based compensation on the income statement does not necessarily correlate with a lower number of shares issued.
In fact, if share prices drop drastically – as was seen with tech stocks in 2022 – stock-based compensation recorded on the income statement may end up being lower, but the absolute number of shares vested could be even more than before. This can lead to even larger dilution for shareholders.
Twilio is not the only company that does not understand stock-based compensation. More recently, DocuSign also suggested that it is targeting stock-based compensation based on a percent of revenue, which shows a lack of understanding of the potential dilutive effects of this form of expense.
Instead of focusing on the accounting “dollars” of stock-based compensation, companies should focus on the actual number of shares that they issue.
Focusing on EBITDA
Too many companies make financial targets based on EBITDA.
EBITDA stands for earnings before interest, taxes, depreciation and amortisation. Although I appreciate the use of EBITDA in certain cases, it is usually not the right metric for companies to focus on.
In particular, EBITDA ignores depreciation expenses, which often need to be accounted for, especially when a business requires maintenance capital expenditures. Capital expenditure is cash spent this year that is not recorded as an expense on the income statement yet. Instead it is recorded as an asset which will depreciate over time in the future. Ignoring this depreciation is akin to completely ignoring the cash outlay used in prior years.
Management teams are either being dishonest by focusing on EBITDA or truly do not appreciate the pitfalls of focusing on maximising EBITDA instead of actual cash flow per share. In other words, they’re either incompetent or dishonest. Either way, it’s bad.
Framing stock buybacks as returning cash to shareholders
Too many companies frame buybacks as a way to return cash to shareholders. However, if we are long-term shareholders who do not plan to sell our shares, we don’t get any cash when a company buys back stock.
Don’t get me wrong.
I think buying back stock when shares are relatively cheap is a great use of capital. However, saying that buybacks is returning cash to shareholders is not entirely correct. Only a small group of shareholders – the shareholders who are selling – receive that cash.
Instead, companies should call buybacks what they really are: A form of investment. Buybacks reduce a company’s shares outstanding. This results in future profits and dividend payouts being split between fewer shares which hopefully leads to a higher dividend per share in the future for long term shareholders.
Naming buybacks as a form of returning cash to shareholders is undermining the truly long-term shareholders who in reality have not seen any cash returned to them.
If a company mistakenly thinks that buybacks are a form of returning cash to shareholders, it may also mislead them to buy back stock periodically without consideration of the share price. Doing this can be harmful to shareholders.
On the other hand, if the company correctly realises that buybacks are instead a form of investment, then the share price will matter to them and they will be more careful about buying back shares at a good price.
Bottom line
Companies do stupid things all the time.
Although I can give them the benefit of the doubt for many stupid things they do, I draw the line when a company cannot grasp simple accounting concepts or make silly statements.
It may seem trivial, but making silly statements shows a lack of understanding of key concepts that mould a company’s capital allocation decisions.
Executives are paid good money to make good decisions and I expect a basic level of understanding from the people who make key decisions on shareholders’ behalf.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Docusign. Holdings are subject to change at any time.