My TSLA Investment Strategy
After a decade of fighting to preserve this illogical status quo, the accounting rule makers finally came to their senses in 2006 and changed the rules on accounting for option grants. In particular, accounting rules allowed companies to grant options to employees and show no cost, at the time of the grant, if the options were at the money. It is at the time of the grant, and arguments that use uncertainty about whether these options will be exercised in the future to justify not expensing them are specious. While businesses with cash flow problems have always used equity based compensation to attract employees, there was a quantum leap in the use of trendy boutique -based compensation by publicly traded companies in the 1990s, driven partly by bad legislation (limiting executive compensation), partly by the entry of young, technology firms into the public market place and partly by bad accounting practices. That may sound like an exaggeration, since the company is transparent about the adjustments that it made to get to its adjusted numbers and the practice it uses is widespread not just among companies, trying to better a better face on their operating results but also among analysts who track these companies.
If my biggest problem as an investor is that the price of something I already hold may go up too much, I am blessed! Given my estimate of value of $648/share, I will continue to hold Apple but I have learned to remain vigilant. However, that does not give you a license to just add back the expense, since capitalizing it will result in an asset that has to be depreciated; see this paper that I have on capitalizing R&D, if you are interested. An argument can be made that R&D expense is a capital expense, not an operating one, and that it should treated as such. Thus, if Twitter wanted to use this rationale, it should have added back just the R&D portion of the stock-based compensation and then subtracted out the depreciation on the synthetic asset it creates. Of course! If you look at why and where companies use stock-based awards, it is more used early in a company's life cycle and it is used to compensate employees.
To explain my reasoning, let me use an analogy. Arena Pharmaceuticals, Inc. (ARNA) - Shares of Arena Pharmaceuticals, Inc. exploded through the high of the day on Thursday but still trades below $2.00. Update: I updated my April 2014 valuations to reflect the current share count of 861.38 million shares, rather that the weighted average share count of 885 million shares that I had used before. Twitter's adjustments shifted a fairly substantial loss exceeding half a billion into both net profits ($9.774 million) and positive EBITDA ($44,745) in the fourth quarter. The dominant add-back in both adjustments is the stock-based compensation of $521.2 million and while it may be sanctioned by accountants, I am struggling with the logic of why. Let's assume that you own and run a business that has an overall value of $100 million and generates $10 million in annual income. One possible explanation that can be offered (and it is a real stretch) is that Twitter views stock-based compensation as an extraordinary expense that will not recur in future years and that the adjusted net income should therefore be viewed as a measure of continuing income. This is the law that is triggering the large stock-based employee option expenses at Twitter and other companies like it, that continue to compensate employees with equity.