For years, investors looked the other way as software companies used their stock to pay employees while the share prices soared. But now that they’re getting pummeled over AI fears, the practice is raising questions.
This is particularly acute for software firms, which are some of the biggest users of stock-based compensation. It allows companies like Salesforce Inc. and Workday Inc. to use less cash to pay their workers and instead plow that money back into their businesses.
When a company issues shares to pay an employee, it’s treated as a non-cash expense even though it still reduces earnings per share. Most software companies exclude those costs when calculating non-GAAP earnings, making profitability appear higher than if they were included.
Last year, for example, Salesforce’s stock-based compensation expense was $3.5 billion. The maker of customer-relationship management software reported adjusted per share earnings of $12.52, which excluded those costs as well as other expenses. Including those costs, earnings per share were $7.80.
This isn’t much of an issue for investors when the stocks are rallying, but they’re more critical in a downturn. A widely followed software exchange-traded fund has dropped 20% this year as investors debate what growth will look like with AI startups like Anthropic and OpenAI encroaching on their turf. That slump is drawing attention to the industry’s reliance on stock-based pay and emphasis on adjusted financial metrics that downplay the costs.
In boom times, the practice “is somewhere between a footnote and completely ignored,” said Jackson Ader, a software analyst at Keybanc Capital Markets. “The way it is viewed in bad times is as a bad corporate practice, and there’s a hint of investors sometimes accusing management of trying to hide the underlying expense base.”
Representatives of Salesforce and Workday didn’t respond to requests for comment.
Criticism of the accounting around share awards isn’t new, of course. Back in 1993, Warren Buffett griped in his annual shareholder letter that they should be treated as an expense just like other costs. If share awards aren’t deducted from earnings, he asked, “Where in the world should they go?”
The biggest technology companies including Apple Inc. and Microsoft Corp. have embraced the inclusion of stock-based compensation in financial metrics. Last month, Nvidia Corp. said it would no longer exclude expenses tied to stock-based pay from adjusted results. That left Tesla Inc. as the only one still engaging in the practice in the so-called Magnificent Seven, which also includes Meta Platforms Inc. and Alphabet Inc.
Now that the threat of AI disruption is causing investors to reassess valuations in the software sector, stock-based compensation is getting a closer look.
On the surface, the median stock in the S&P 500 Software & Services Index trades at slightly less than 20 times adjusted forward earnings, broadly in-line with 18 times for the median member of the S&P 500. Adding share-based compensation and other costs back in, the median software stock trades at 26 times, a 28% premium to the median S&P 500 component. Salesforce, for example, is trading at 24 times GAAP earnings, compared with 15 times non-GAAP earnings. Workday’s valuation is 29 times GAAP earnings versus about 12 times adjusted profits.
“Stock-based compensation of many of these companies has been way out of proportion versus the economic GAAP earnings,” said Manish Gupta, a portfolio manager at First Eagle Investment Management. “And that’s why some of these companies are not cheap, despite claims of being valued quite attractive.”
There are other problems related to software companies’ reliance on stock-based pay when the shares are sinking. Employees who receive stock awards take home less as share prices fall. That makes retaining talent a challenge and the firms often come under pressure to pay more in cash.
“Falling share prices can exacerbate these issues because it is likely that companies will have to increase compensation to retain key staff,” said Nick Evans, a fund manager at Polar Capital. “In this sense, future consensus earnings or cash flows may be overstated as they may not fully reflect this incremental expense.”
This makes share buybacks important for software executives as their stock prices fall. While companies like Salesforce have moved to aggressively repurchase beaten down shares, offsetting the dilution from stock-based pay is another attraction.
Ultimately, the use of stock-based compensation comes down to a question of which numbers investors accept. Technology companies have convinced the market that the adjusted figures are the ones to watch, but that’s changing. And at the end of the day, regardless of whether employees get shares or cash, it’s all expense, said Patrick Burton, a portfolio manager at Winslow Capital Management.
“It’s our second awakening in the last six years around this topic,” he said. “Some people who didn’t view it as an expense — at the board level, or CEO, CFO level — now do. And they are not just paying lip service to the issue. They are starting to really address it because it hurts on them.”
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Written by: Aya Wagatsuma and Momoka Yokoyama — With assistance from Margaryta Kirakosian, Ryan Vlastelica, Luz Ding, Subrat Patnaik, and David Watkins @Bloomberg
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