Square (NYSE:SQ) stock trades at 79 times its earnings but it has only risen 13% or so this year. Meanwhile, the S&P 500 trades at just 22 times earnings, almost one quarter less than SQ stock. But the S&P 500 has risen 19% this year.
This does not make much sense. Square is expected to grow its earnings this year to 77 cents per share from a loss of 9 cents a share last year. And next year SQ is expected to make $1.11 earnings per share, according to Seeking Alpha.
That still puts it at 56 times earnings produced by the end of 2020. And it assumes that earnings will grow 44% during 2020. But keep in mind that Square is still not profitable as of the end of Q2 2019.
As SQ stock has only risen about 13% this year, why is everyone paying up for SQ stock, when, in reality, it is a dud? Especially compared to the S&P 500.
Abracadabra Accounting Adjustments at Square
For example, Square reported that it lost $6.7 million in Q2 in net income as well as $44.9 million in the first half. But Square has a way of converting those losses into positive profits. It reported “adjusted” EPS of 21 cents per share for the June quarter and 31 cents for the six months.
These adjustments make Square stock look more profitable than it really is. To make its first-half profits turn positive from negative, it adds back, or “adjusts” expenses that GAAP accounting requires all companies to expense. The largest of these expenses are stock-based compensation expenses (SBC).
SQ adds back $140 million in SBC expenses to its $44.9 million losses in the first of 2019. The magic wand waived — now Square is deemed profitable on a non-GAAP basis.
The problem is that the vesting of these SBC expenses will eventually come to pass. Over time the restricted shares will be issued, and options come into play. So to effectively delete these expenses continuously over time is erroneous and not realistic.
Profitable Tech Companies Don’t Need to Adjust Their Earnings
Truly cash flow profitable tech companies do not need to make these stretched non-GAAP adjustments to show that the company is profitable. For example, Alphabet’s (NASDAQ:GOOG, NASDAQ:GOOGL) latest financial release does not add back SBC expenses and non-GAAP EPS figures.
This is because Google is extremely cash flow positive. But Square is not cash flow-positive. That may come as a surprise to some since Square reported adjusted EBITDA of $167 million in the first half of 2019. It also had free cash flow of $135 million in the same period.
But here is the whole picture. After deducting $106.6 million in “payments for tax withholding related to vesting of restricted stock units” and other items, Square’s first-half cash flow statement only increased cash by $30 million. For example, although cash flow from operations was $165.8 million, its cash flow from investing was -$95.8 million and cash flow from financing was -$42.4 million.
The point is that Square is not really all that cash flow profitable. The cash and non-cash costs relating to vesting reduce profits. The temptation then to adjust earnings selectively in non-GAAP measures by Square was too high to avoid.
The Raging Academic Debate on SBC Expense Add-Backs
To be fair, there has been a raging academic debate about whether SBC expenses need to be deducted. For example, the Financial Times had a very insightful article on June 10, 2019, “Why Investors Should Be Wary of Stock-Based Compensation.” The article argues: “If an employee is paid with options or restricted stock, it will hit your share’s value.” The practice of adding back SBC expenses by analysts is misguided.
The Financial Times article also quotes Warren Buffett on the subject. He said this:
“If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses shouldn’t go in the calculation of earnings, where in the world should they go?”
An article in Accounting Today in April 2017 goes through the history of the debate in the Financial Accounting Standards Board (FASB) and resistant companies, even Congress, on the issue. Another article argues that adding back SBC expenses in discounted cash flow (DCF) valuation analyses is almost always wrong.
Maybe That Is Why Square Stock Hasn’t Risen Much
The point is maybe you can’t really fool the market. Square stock is too expensive for real growth. There is not much real growth after taking into SBC-related expenses. SQ stock is only up 13% this year as a result, a lot worse than the market index.
So be careful when analyzing SQ stock and listen to the company’s earnings announcements. Make sure that you take all the related expenses into account that the company wants you to forget.
Here is another way to look at Square stock: If you are going to pay almost four times market value for a stock, maybe there should be some really good reasons why that stock will outperform the market, not underperform it.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide which you can review here. The Guide focuses on high total yield value stocks, which includes both dividend and buyback yields. In addition, subscribers a two-week free trial.
