I actually agree with a lot of what you write. But not everything.
For example, the idea that a positive profit can not be reduced to a negative one by handing out shares is, in fact, true (on the whole).
However, from the perspective of an individual shareholder there is an equally valid point of view. It is possible for a company to report positive earnings but to do so in such a way that the shareholders' (plural, possessive) value is reduced. Which is, from the point of view of these shareholders, not a profit but a loss.
Do I need an example? Here: consider a company with 100 shares with $100 in the bank, with employees who through their efforts bring in $100 of earnings to the corporation. If the company suddenly issues 100,000 shares to the employees at no cost to the employees (e.g. as a Stock Option), then of course there is no way that $100 in earnings will be reduced to below zero, or even a dime below $100.
The company will still have increased its assets by $100.
And while those owners of the first 100 shares will see their share of the profits go from $1.00 to $0.001 (still positive), they will also see their share of the existing assets of the enterprise go from $1.00 to $0.001! Which is a reduction in value!!!
From their perspective, the cumulative actions of management resulted in them having a holding worth $1.00 get reduced to a holding worth $0.002, which is indistinguishable on a "value increase over time" perspective from management having achieved $0.998 loss!
Furthermore, this is not the same as having achieved a fully diluted EPS of $0.001 either, which might lead shareholders to think that their share of the pie has increased from $1.00 to $1.001
And finally, if management is rewarded as though they just increased shareholder value to the tune of $1.00 (or even $0.001) per share, when in reality they have reduced shareholder value by almost as much, then the odds of them continuing in this vein are quite high! After all, if one can get rewarded by reducing shareholder value by $1, why bother trying the even harder task of increasing shareholder value, only to get the same reward? Management might be many things, but stupid isn't one of them.
Now you can quite correctly say that this company's practice is not EQUAL to one which set about losing $0.998 per share. And point out all kinds of differences. I agree with you. There are material differences. That does not mean that the rate of change of shareholder wealth is not COMPARABLE.
Very few things on the planet end up being equal. The issue isn't equality, it's a basis from which to measure degrees of inequality and reduce multi-dimensional problems to a scalar quantity. Often measured in dollars.
While you maintain that this is theoretically impossible, and indeed I agree: precision is impossible to attain. However, the fact remains that an attempt is practically necessary. In fact, as impossible as it might be, we see it being done every day. Companies report "goodwill" and "inventory" and and "accounts receivable net of doubtful accounts" and so on. All are subjective measures of value reduced to dollar amounts when you get right down to it. The theoretical impossibility of being absolutely correct is irrelevant. There are merely practical consequences of not getting approximately near that are worse than the consequences of applying a number that isn't quite right!
If you disagree with me, next time you pull out your wallet to pay for something, how about having an argument with the clerk that it's impossible to settle on a fair price for whatever it is you are buying. See how far that gets you. Not very. In the end, you have a choice: buy it at a price, or shut up and go away. And the vendor has a choice: sell it at a price or ask you to go away.
The issue of mutually beneficial exchange is indeed important, and is not being set aside in this debate. When you buy a packet of peanuts for a dollar, the utility to you of a dollar is less than your utility for a packet of peanuts. And to the vendor, the utility of a dollar is greater than the utility of a packet of peanuts. The value of the exchange is $1, plus or minus some unknown utility, depending on who you ask.
What is the value of that pack of peanuts? Theoretically it can take any value. It is not zero. It is arbitrary, and in theory the question is impossible to answer. You and I can agree on that.
However, it turns out to be expedient for any number of purposes to provide an answer to this question. And so it gets asked. And answered. And often because the consequences for not answering are worse than those for getting the answer wrong... the response "no value" is rare.
Another perfectly good piece of theory is dashed to bits on the rocks of practicality. And we try to come up with a number using some time-honored principles.
To you, at the moment of exchange, it was worth AT LEAST $1.00 in cash, and at that same time, to the merchant it was worth NO MORE THAN $1.00 in cash according to the principle of mutually beneficial exchange. Drawing a straight line between the two data points gives us a price of $1.00 in cash, with a bit of non-cash uncertainty on either side.
One might stare in misery at the unquantified uncertainty and say "oh shucks, let's call the value zero".
Or one might say, no, that too would be wrong, and that would be shirking what we have been asked to do, which is to put a value on that packet of peanuts. The idea isn't to be right, just "least wrong".
And by long-established convention of "market pricing", the "least wrong" value for that packet of peanuts would be $1.00 - given the data on the table. And we can at least be comfortable that the value does indeed lie within a range that the parties in the exchange would find reasonable.
So in the end we can put a value on an exchange. It may not be the correct value in everyone's eyes, but it is a value that is least likely to be wrong considering all eyes.
These two practical matters - equivalence versus equality and "value" versus "worth"... they really make a botch job out of a perfectly theoretical world.
But they help things to move along smoothly.
The point about stock options is that from the perspective of owners they are a cost. Even if we can't agree on how to quantify this cost, you and I agree that it is a cost because we agree that anything which reduces the value of a shareholder's holding is a cost. Sure, options are intended to attract a benefit, but then so is a salary, and nobody even tries to argue that since salary is designed to attract a benefit that it isn't a cost. To shareholders, options are a cost!
What is this cost? Well, it can be reduced to a monetary equivalent (opinions vary on the process, and on this I think the prognosis is bleak that we might agree). And this monetary equivalent is non zero. But we can even set this aside for the moment.
Because when management issues stock options and uses these to deliver "earnings", the net "profit" to the shareholder is the sum of the value created minus the value given away. Clearly shareholders aren't being made as well off as if the only thing management is doing is generating that "earnings" for them.
Now, we can argue if you like that it's impossible to account for the value being added in the same terms as the value being taken away. And in the general theoretical case of all transactions this might even be true. In the case of financial instruments however, and stocks in particular, when the common denominator is dollars, it turns out to be a mere computational nuisance.
It turns out to be quite possible to measure the "profit" that shareholders are receiving as a consequence of the actions of management. It is precisely equal to the "earnings" that the company is reporting that is increasing shareholder value, minus the dilution cost that management has incurred. Both expressed in dollars.
Assuming that we can agree on how to reduce stock option cost to dollars, we could agree on the profit that management delivers is therefore "earnings" minus "stock option expense".
Now, if the earnings report of a company is intended to be management's report to shareholders about how well the company is doing in making them wealthier, then the bottom line, the only number that counts, is this sum. Otherwise, we might as well just ask them to just report revenue and leave the icky bits as something to "pro-forma" away.
It is very hard to argue, from the perspective of a shareholder, that stock options should not be set against reported earnings when determining the "profit" of a company.
John |
