Commentary
Technology investors had a rough year in 2022. The Nasdaq Composite Index went down by about 33 percent.
Despite a rebound so far this year, investors are faced with lower revenue growth and a significant structural hurdle—consequences of increasingly higher stock-based compensation awards.
This isn’t a new phenomenon. Technology firms have been gifting lucrative stock and option grants to attract talent. And for a long period of time, investors ignored them. Stock prices went up year after year. There was no need to dive into esoteric financial statement reconciliations.
But this is no longer 2018. Higher interest rates mean high discount rates in valuation models, and the technology companies’ future cash flows are no longer worth as much on a present value basis. The meager valuations must now be divided among more share units.
It’s called dilution, and it’s no longer just a concern of corporate finance analysts.
The dilution effect from years of handing out stock awards will negatively affect share performance going forward, according to a column in the financial magazine Barron’s.
Let’s summarize what happens when companies issue stock to employees. There are generally two types of compensation. First is cash compensation, paid in the form of a base salary and various kinds of bonuses. The second is stock, in the form of stock awards or stock options. In theory, there’s alignment with shareholders by pegging compensation to future stock performance.
Stock awards are considered a noncash expense, and accounting rules allow them to be amortized over a number of vesting years in a company’s financial statements to mitigate the annual impact. Most companies don’t even include stock-based compensation in their non-GAAP adjusted results included in quarterly earnings presentations. It’s a well-hidden expense and a clever way to artificially prop up the bottom line.
When stock awards vest, the new shares are issued, and they increase the number of shares outstanding. In other words, more shares are created, and existing shareholders keep less of the pie.
What this means is that unless a company’s earnings are growing at a higher pace than dilution, each share of stock is theoretically worth less than before.
To be clear, this isn’t just a compensation tactic practiced by tech firms. But tech firms on average use this type of compensation to attract and retain employees more than other sectors.For many years, revenues grew rapidly and share prices increased accordingly. This enriched both employees at these technology companies and their shareholders.
And over the past decade, this trend has become an ever larger part of companies’ expense structures. One study found that the average stock-based compensation amounted to just 4.2 percent of revenues a decade ago for the technology sector. This ratio increased to 10.5 percent in 2020 and then skyrocketed to 22.5 percent in 2021. Full data for 2022 aren’t yet available, but this trend is expected to increase even further.
Close to 25 percent of a given company’s revenue is an expense that’s largely hidden from view. That’s an alarming metric, especially in a period of declining revenue growth.
For the 2022 cycle, those awards will turn into an even higher number of shares when they’re granted, meaning that the rate of dilution is going to be even higher.
Here’s why: Stock awards are based on a dollar value. To keep it simple, suppose an employee receives $100,000 in stock award in any given year. When the stock is trading at $100 per share, the employee receives 1,000 shares. Now, suppose at the end of 2022 the company’s stock price had tumbled to $70. That same $100,000 award at the end of last year translated to almost 1,430 shares handed to the employee.
If you’re an outside investor of this company, you'll be subject to a much higher rate of dilution today.
Security software company Okta, big data platform company Confluent, and cloud computing firm Snowflake were among the companies that handed out the large stock grants as a percentage of revenues last year.Of course, a higher proportion of employee stock grants alone isn’t a reason to shun a company’s stock. But astute investors should pay close attention to how a company reports its earnings in these times of heightened volatility.
