The accounting requirements for stock compensation are broken and distort the underlying economics involved. Investors need to be aware of how it is broken, and make adjustment for it in their assessment of companies.
A notable recent example concerns the compensation of Tesla CEO, Elon Musk. Unless you're living under a rock you will have seen headlines concerning a Delaware judge voiding Musk's "$56 billion pay package".
What you may not be aware of is that the actual expense recognised in Tesla's books is closer to just $2bn.
The $56bn figure is closer to the actual expense to the company, that consists of granting 304 million options to purchase Tesla stock at an exercise price of around $23/share, or nearly 90% below the stock's current market price.
The reason for this dramatic disparity is that US GAAP accounting requires that the maximum cost of this compensation plan be determined at the inception of it, based on a Black-Scholes model. $2bn was the number this model spat out back in 2018. $56bn is the approximate market value of those options today.
This situation is like an options trader naked shorting call options and being able to cap any adverse P&L impact of doing so based on a Black-Scholes model at the time they open their naked short position. In doing so completely ignoring the actual economic cost. Obviously patently ridiculous but this is what US GAAP requires of companies.
This is separate from any discussion around the merit of the shareholder approved award to Musk. The award is subject to appeal in Delaware but there is also a shareholder movement to have the award ratified by shareholders again, in doing so addressing any inadequacies in the original approval - whether real or imagined by the Delaware judge.
My suspicion is that a constraint to such a reapproval may be that this would require the real cost of the plan to be recognised in Tesla's financials, which would not make for pretty reading. $56bn represents about 200% of Tesla's retained earnings since inception.
It must also be noted that the misleading accounting here does not reflect a failure of Tesla, or any one company, but rather of the standards boards that set the accounting requirements. Tesla reflects merely one dramatic example of the economic distortion, but this situation is not unique to Tesla, and investors need to be aware of it when assessing businesses.
Another striking recent example that has received less press is that of Nvidia, whose Free Cash Flow generation can so easily be significantly misinterpreted as even more impressive than it really is.
In their recently reported financials Nvidia shows "Stock-based compensation expense" of $3.5bn, and "Payments related to the repurchase of common stock" of $9.5bn.
