Imagine you own a local coffee shop. You sell $1,000 worth of coffee, but you owe your barista $200 for their shift. Your profit is clearly $800.
Now, imagine you tell the barista: "I won't give you cash today. Instead, I’ll give you a small ownership stake in the shop." Since cash didn't physically leave the register, you decide to tell your investors your profit is still $1,000.
Does that sound honest to you? Of course not. You still paid for the labor, just with equity instead of currency.
Yet, this is exactly what happens on Wall Street. It is called Share-Based Compensation (SBC), and understanding how it distorts earnings is critical for protecting your wealth.
The Rise of "Adjusted" Reality
In recent years, particularly in the Technology sector, paying employees with stock options has become the standard. There is nothing inherently wrong with this; it can align employees with shareholders.
However, the accounting has become a problem.
In the S&P Dow Jones Technology Select Sector Index, SBC expenses rose from 2.2% of revenue in 2011 to 4.1% in 2021.
This increase happened even though revenue for these companies quintupled on average during the same period.
The issue isn't the payment; it's the reporting. Many companies report "Non-GAAP" (adjusted) earnings where they pretend these costs don't exist.
In one study of 75 tech companies, 45 of them removed SBC from their earnings figures.
This erased about $26 billion in real expenses from their reported results, artificially boosting profits.
The Three Flawed Excuses
CFOs usually offer three justifications for ignoring these costs. Here is why they don't hold water:
1. "It’s a non-cash expense."
This is the most common excuse. But plenty of real costs are non-cash. Depreciation (the wear and tear on a factory or server farm) is non-cash, yet no one argues we should ignore it. If you want to see cash movements, look at the Cash Flow Statement, not a manipulated profit and loss account.
2. "It’s too hard to estimate."
Companies argue that share prices fluctuate, making the cost outside their control. But companies constantly deal with fluctuating commodity prices and interest rates, yet those remain in the financial statements. Just because a cost varies doesn't mean it isn't real.
3. "Everyone else is doing it."
This peer pressure argument suggests that because other tech firms adjust their numbers, it is acceptable. But popularity does not make an accounting practice correct.
Why This Matters to You
When a company ignores SBC, they are essentially saying their employees work for free.
If you accept these "adjusted" numbers, you might think a stock is trading at a bargain valuation. But remember: when a company prints new shares to pay staff, your ownership stake is diluted. This impacts the balance sheet and the number of shares outstanding.
The Bottom Line
Wealth is built by seeing reality clearly. When you read an earnings report, always check the gap between the "Adjusted" number and the official GAAP number. If the gap is massive, ask yourself: Are they really this profitable, or are they just paying their bills with printer ink?
What’s your take? Do you trust "Adjusted Earnings," or do you stick to the official GAAP numbers? Hit reply and let me know.
To your compounding success,