Tech sector profitability comes with a catch
Double standard: the tech sector's love affair with adjusted earnings
How stock market favourites Amazon, LinkedIn, Facebook and Google adjust their earnings to overstate perceptions of profitability and understate risk.
It’s now common practice at fast-growing companies like Amazon, LinkedIn, Facebook and Google to present alongside standard earnings a modified figure that excludes stock-based compensation expenses. This measure, according to critics, can inflate investors’ impression of a company’s profitability and understate the level of risk attached to certain stocks.
To be sure, there is nothing illegal about the way high-tech earnings are reported. As required by accounting standards in both Canada and the United States, the cost of rewarding employees with various kinds of stock awards appears on the income statement. The issue is the growing habit of adding an alternative measurement – usually referred to as adjusted earnings – in which those and other costs are added back. The result? An apparently higher level of profitability.
"A lot of these companies are not as healthy as you think they are."
- Ramy Elitzur, the Edward J. Kernaghan Professor in Financial Analysis at Rotman
Companies are “not manipulating the financial statements, they’re trying to manipulate the perception of investors,” said Ramy Elitzur, an accounting professor at Rotman.
Adjusted earnings take Amazon’s estimated price-to-earnings ratio from about 455 all the way down to 151. While LinkedIn’s P/E based on its earnings under generally accepted accounting principles (GAAP) is 1,103, its P/E ratio using adjusted profits shrinks to 138. Salesforce.com goes from a loss to a profit.
And it’s that rosier take that is offered up by many tech enthusiasts as the more faithful representation of earning capacity. For the most part, investors and analysts happily oblige them.
Stock options were a key element of employee compensation at many tech companies during the dot-com boom. They were used to attract executive talent and – in theory – to align executives’ incentives with shareholder interests. Since they did not involve the outlay of cash, they were kept off the income statement.
The accounting establishment mostly disagrees with this practise. If not for stock awards, companies would have to pay higher salaries, Mr. Elitzur argues. “You’re utilizing resources in order to generate income. That makes it the equivalent of salaries.”
Investors’ impressions can be swayed by tech companies proclaiming the superiority of adjusted earnings, said Barry Schwartz, vice-president of Baskin Financial Services. “It’s just one snapshot of the health of a company, and a lot of these companies are not as healthy as you think they are.”
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