Hi Fuller OT..... It's also hard to believe this one :-)
This is from a site called goldensextant? It clarifies my question to you
regarding Microsoft's accounting practice of paying employees with stock
options. Doesn't look good for them and further compounds the mania we are
seeing of late.
Steve
Although not added to the Dow until only a couple of weeks ago, Microsoft as
measured by stock market capitalization is the world's largest company. Even
after its antitrust setback and despite the obvious new challenges it faces,
it continues to trade at a trailing PE around 60, nearly twice both its
5-year earnings growth rate and its average annual PE as reported by Value
Line. It pays no dividend and has a book value around $5, but these criteria
are deemed of no relevance at all in the current new era. In a recent online
analysis (www.billparish.com/msftfraudfacts.html), a Portland, Oregon,
investment firm contends that under proper accounting practices, Microsoft
is not even profitable. It is not necessary to accept this startling
conclusion to appreciate two fundamental and very real problems that this
study points up.
The first is the effect of stock options on reported wage expenses,
particularly in the technology sector. In a bull market, employees are
willing to take stock options in lieu of salary. When exercised, the
employee is taxed on the basis of market value. That is, the difference
between the exercise price and the market price is treated as income, on
which the employee is then taxed regardless of whether the stock is sold.
The market price thus becomes the new basis for future capital gains taxes.
The company takes an income tax deduction equal to its tax rate times the
employee's calculated income, but typically records no corresponding charge
to earnings on its P&L. Thus, while the newly issued stock causes dilution
in per share earnings, the wage or salary expense that it represents -- the
difference between the market price at issuance and the exercise price --
does not impact earnings and increases reported cash flow by the amount of
the tax deduction.
Whatever one thinks about the accounting conventions that apparently allow
this treatment, it is clear that companies compensating large numbers of
important employees in this fashion are headed for significant financial and
personnel problems should their stock prices merely level out, never mind
fall. What is more, this situation produces substantial incentive for
companies to try to push their stock prices ever upwards by managing
earnings, repurchasing shares, or in Microsoft's case even selling put
options to institutional holders of large blocs of its stock. Indeed, sale
of put options has in recent quarters generated a not insignificant amount
of cash for Microsoft while allowing some of its largest shareholders to
enjoy at least the illusion of protection.
The second problem underlined by the Microsoft study is the danger of stock
indexed investing done with no regard to underlying stock values. The
1972-1974 bear market, which took the Dow from over 1000 to under 580,
ended
the "Nifty-Fifty" era and discredited the widely held belief that smart
investing consisted merely in buying and holding a few blue chip or
so-called "one-decision" stocks. As a practical matter, this belief is
reincarnated today under the guise of index investing, a perfectly valid and
useful concept until taken (or gamed) to nonsensical extremes. Throwing
funds at capitalization-weighted indices while remaining blind to the
underlying value of their largest components has produced extreme
overvaluations in certain "gorilla" stocks.
Like Microsoft, many of them are technology stocks, allowing their "new era"
aura to trump more mundane considerations relating to profitability and
sustainable growth rates. Among the Dow stocks, they now include after the
recent changes: AT&T, Hewlett-Packard, IBM, Intel, SBC Communications and
Microsoft. Others include: AOL, Cisco, Dell, Lucent, MCI Worldcom and Sun
Microsystems, six stocks which on November 15, 1999, had a total combined
capitalization just over $1 trillion, a mean PE ratio over 65, and an
average PE ratio over 100.
Industrial and consumer stocks, too, have been swept up in the indexing
mania. More than anything else, index investing explains why General
Electric, the next largest stock based on capitalization after Microsoft and
also a Dow stock, can trade at a trailing PE over 40 when until 1996 it
almost never traded at an average annual trailing PE exceeding 15. What is
more, not one of its historic or projected growth rates (sales, cash flow,
earnings, dividends or book value for the past 10, 5 and next 5 years) as
reported by Value Line exceeds 15%.
A few months ago an experienced investment manager asked rhetorically in a
Barron's interview: "Who is going to buy GE at a PE over 30?" Now he has his
answer: index investors, the same people who buy other gorilla stocks at
eye-popping PE ratios. Who are these index investors? Many of them are the
country's largest pension funds, making the prospect of fair valuation in
the largest cap stocks so unnerving as to render a bear market virtually
unthinkable. According to the Microsoft study cited above, the California
State Teachers Retirement System owns more than 16 million Microsoft
shares
with a value of about $1.4 billion based on its commitment to indexing
against the S&P 500, of which Microsoft accounts for about 4%.
Unfortunately, particularly in the investment world, "unthinkable" and
"impossible" are not the same thing.
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