Educate yourself on the shell games of Wall Street

Tuesday, July 7th, 2015

During the tech boom of the late 1990s, it became well-known that many companies were using options to pay their employees and not taking the expense of a salary.

Due to the complexity of options, that practice is now gone. Unfortunately, Wall Street and primarily technology companies have found another way to reduce expenses and artificially inflate their income by using something known as stock-based compensation.

This whole stock-based compensation came to light when Morgan Stanley's Chief Financial Officer Ruth Porat left to take a job as chief financial officer of Google earlier this year.

At Morgan Stanley, her bonuses, salary and total compensation amounted to nearly $14.38 million, of which Morgan Stanley took an expense on their income statement of that amount.

Google gave her nice pay raise with total compensation of $30.65 million, of which only $650,000 was her base salary. Google expensed only the salary and did not include the millions she will receive in stock as an expense.

There are many problems with this.

First off, some companies do expense the stock-based compensation and some do not, so how is an investor going to make a fair comparison without digging deep into the financial statements?

Second, the company is overstating its income by playing hide-and-seek with its expenses. This is the same shell game that got investors in trouble during the tech boom when everything looked so rosy.

A partial list of companies that abuse accounting rules and do not list stock-based compensation includes Google, Facebook, Twitter, Amazon, Salesforce and even Qualcomm, which was a surprising disappointment to me.

As an investor, when you compare these names to companies including Apple, Intel and others from financials to industrials, it is not a fair comparison.

I know the stock of Facebook and Salesforce has done very well over the past few years, but many people, including brokers, don't understand why these stocks are going higher or the true value of these companies.

I cannot tell you when things will change, only that historically, every time a stock or a group of stocks become overvalued, they eventually come down to a normal price to earnings.

You may be wondering what difference it makes if a company issues shares to its employees, because they really had no out-of-pocket expense.

What you may have seen before is where a company is buying back stock and either using its cash or borrowing money to buy that stock, but the shares outstanding continue to rise. The reason for the increase in spending to buy back stock is that the company is giving those shares to highly paid executives and some to employees as incentive.

There is no expense for that, but the company is using its cash that it could be using to actually reduce the share count or reinvest back into the business. The company could also pay out dividends to its shareholders with that cash.

For example, Google has $65 billion of cash and short-term investments, yet over the past year its shares outstanding have increased by 8 million.

Also, by issuing new shares there is a dilution of earnings that affects all the shareholders. The reason is the pie is always the same size. However, as you increase the number of shareholders, the slices will be smaller because more people want to share in that pie.

On my radio show I talk only about Generally Accepted Accounting Principles earnings estimates because we want to do a fair comparison of all companies.

Let me give you another example of a company that investors were very excited about: Twitter (NYSE: TWTR). Over the past 12 months this stock has been as high as $55 a share and as low as $33 a share. It now trades about $35 a share. In December 2013 the stock briefly touched $75 per share.

We all know Twitter, but it comes back to whether the company has earnings and will investors pay a reasonable price for those earnings. If investors would look at Yahoo Finance for the earnings estimate ending December 2015, they would see a mean estimate of 34 cents per share. And they may get all excited, saying, ‘Wow, Twitter is now making money.’

Twitter appears to be one of the most abusive companies when it comes to using stock-based compensation.

For 2015, Twitter’s stock-based compensation is estimated to be $770 million. Using a fair comparison to other companies such as Apple or Microsoft, the real earnings for Twitter are not 34 cents for the year but a loss of 90 cents for the year.

Investors wonder why they can't make money in the stock market over the long term. It is because there are many secrets on Wall Street that only professionals know.

I enjoy sharing these with you so you understand that investing in stocks is not risky if you have someone do the correct research and understands the ins and outs of reading financial statements.

So the reason this abuse continues to happen is that many investors, managers and street analysts would rather paint a rosy picture for some companies than tell the truth.

This causes many people who don't understand investing to lose money and not understand why. It is time investors understand the tricks that Wall Street plays so they can make a decent return by investing into fundamentally strong companies.

Do you have a question or a company you'd like me to take a look at? Email me at Brent@WilseyAssetManagement.com!


Wilsey is president of Wilsey Asset Management and can be heard at 8 a.m. every Saturday on KFMB AM760. Information is provided by Reuters.

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