Stock options have long been seen as a double edged sword, great for young start-ups who can look ahead to a bright future of soaring valuations, rubbish for mature companies who may well find their stock price on a mid to long term slide. In the case of the latter instance, cash beats options hands down.
Share options can also turn into something of a Ponzi scheme. Is your share price falling? Fine, offset it by giving employees more stock. Don’t have enough to do the job? Fine, issue more stock. This is analogous to a central bank running the printing presses. Dilution sets in, stock values plummet, you issue more stock until boom, it’s next to worthless.
Which brings us back to Facebook. In Part One I mentioned that Barrons took a dim view of Facebook from the get go and that its view, if anything, has got grimmer. Part of the problem, Barrons intimates, is Facebook’s vast issuance of stock options to employees and the way, so far, analysts have failed to factor the cost of Facebook’s stock options into their calculations about future earnings and future prices. If market analysts won’t do the job, Barrons will do it for them:
“Facebook issued $1.4 billion of restricted stock in 2011, or nearly $500,000 per employee. So far this year, the company has doled out $1 billion of restricted stock. Facebook's reported stock-based compensation expense—based on the amortization of several years of stock grants—could total 20 cents a share next year. Subtract that from the 2013 consensus earnings number (63 cents a share), and the shares [will be trading at current prices] at 50 times earnings. At $15 they would still be valued at a rich 35 times earnings.”
To see why this is problematic, Barrons points to the comparative price/earnings model for two other technology giants, both vastly more established than Facebook, namely Google and Apple.
[caption id="" align="aligncenter" width="537" caption="Facebook (FB) Stock Chart in comparison with Apple and Google in the past five months"][/caption]
In September, Facebook was trading at 47 times the projected 2012 profit of 48% a share (which it may or may not achieve). Even if the company achieves the consensus earnings of 63% a share in 2013, the current stock price would still have it trading at 36 times estimated earnings. By comparison both Google and Apple trade at roughly 16 times estimated 2012 earnings. What on earth suggests that Facebook, which has some huge challenges ahead – not the least being the drift to mobile and away from its heartland of the desktop PC – has the mojo to prove itself two to three times better than Google and Apple? People camped out for a week to be first in line to buy the iPhone 5, daft as that sounds. Where is the equivalent product pull for Facebook?
Moreover, as Barrons points out, even with the fall in the share price, Facebook still looks way overvalued:
“Facebook is valued at $61 billion, or $53 billion excluding its estimated $8 billion in cash. That's more than 10 times estimated 2012 revenue of $5 billion. Google trades for half that valuation.”
Silicon Valley has long taken the view that only cash expenses matter and options, not being cash, don’t count and should be ignored by prospective investors. As Barrons notes:
“Technology is the only major industry where companies routinely encourage analysts to ignore stock-based compensation expense.”
Eventually, stock based compensation comes home to roost as a real expense. The hope is that it does so when the stock has soared to such stratospheric heights that no one is going to quibble.
The bull market view of Facebook is that its current annual revenue of $5 per user will double or triple relatively quickly. It will have to. Facebook’s second quarter revenue rose by 32% while its expenses rose by 60%. Not too many companies would be thrilled with that relationship, particularly when Facebook is projecting similarly high expenses through the final two quarters of the year.Zuckerberg may be in control but he is going to have to pull his hoodie way up over his ears if things don’t turn up soon – or the noise from the markets is going to make life uncomfortably noisy for the man who wants to connect the world.
Further reading on stock options
- Employee Stock Options, by Peter Casson
- Balancing Senior Management Compensation Arrangements with Shareholders’ Interests, by Henrik Cronqvist
- Executive Rewards: Ensuring That Financial Rewards Match Performance, by Shaun Tyson
Tags: Barrons , Facebook , Facebook IPO , Ponzi scheme , stock options , stock-based compensation schemes , stock-based merger arbitrage