Mike,
this fellow (Oro) posting on USAGold forum has some interesting things to say. What's your take on his analysis?
usagold.com
ORO (12/16/99; 16:45:51MDT - Msg ID:21166)
SteveH - ESOPs and the NASDAQ Index
Since the break with reality in pricing these Nasdaq stocks in 1997, there has been a new reality setting in. It is driven by stock options compensation. As I have pointed out before, extending from Bill Parish's work, the profitability of high technology companies is now only a function of their ability to maintain revenue growth. The profitability of sales is non-existent. The profits of the typical high tech company are made in three ways from ESOPs: (1) IRS tax credits - on the order of magnitude of net income, sometimes higher, sometimes lower. (2) Wage compensation and wage tax savings, on the order of 75% of wage compensation - some higher, and on the order of 75% or Revenue. (3) Selling of stock put options to investors as a substitute for stock repurchase with cash supports the stock price while often supplying heavy cash flow.
Quite frankly, the technology industry - internuts included, are stock market bucket shops. The only necessary reference to their business in the real economy (as opposed to the financial one) is to having sufficient revenue to be able to hire employees and pay them some cash compensation as they wait for the stock options to vest and for the stock price to rise. The software and technology/communications hardware industries faced the prospect of having earnings go negative if they had not obtained the accounting benefit and favorable IRS treatment of ESOPs, because of the fall in available high tech talent that they needed just to stay in business - not to speak of turning a profit. By the time the enabling administrative rulings and legislation were passed, Silicon Valley had consumed most of the world's top high tech talent - no, it is not local, but spread from Tel-Aviv to Taiwan through India, Singapore, and Ireland, as well as Britain, Sweden, and Denmark. The shortage is getting so much worse that non core R&D has long moved off-shore, and some core products and research is done in politically hazardous locales.
The revenue is obtained by the sale of services and products at a 30% to 50% discount to cost. Contrary to much of the New Paradigm thinking about R&D being an investment that should be amortized, whereas that may have been the case in "old line" industries, it is not so in high tech. The typical high tech product contains "innovation" from the previous cycle of development - typically two years in length followed by repair work for one to two years after sales begin (look back to my post on cost of quality in high tech -
software in particular). Thus cost of sales continues well past the sale itself, as software patches and hardware add-ons are produced so that the revenue generating sale of an item - that did not do its specified job - is not reversed or future sales damaged. These are the 100% lemon cars produced by US auto manufacturers in the early 70s (final assembly at the dealer's and in your driveway). This would indicate that expensing current R&D is appropriate for software and not a significant distortion for hardware. For internet media companies, the R&D and Marketing expenditures, are likewaise, if the effort does not expire within two years of product creation, it would likely expire within less than one.
What is grossly evident in Amazon.com is not new. Generating revenue at a loss is the name of the game in order to gain market share, retain scarce talent, and thereby, survive. The cash flow and reported earnings come from the stock market and the tax payer, as well as the employees themselves.
If return on these operations was so high, the corporations would have borrowed in order to do their version of investment - R&D and advertising. The issue is that beyond normal business risk, the revenue generated by this investment is unprofitable, often smaller than the "investment". That would never attract a lender. However, prior experience has taught stock investors to follow the revenue trail - the Yellow Brick Road - at the end of which is the Wiz and his city of Oz, a.k.a. capital gains. In the way of encouragement of self fulfilling prophecies, the market expectations are used to directly subsidize revenue and are introduced into the bottom line when monetized by the employees and the IRS.
The typical math is 10%-40% of Market cap is outstanding in ESOPs (particualrly for upper management) with 20% being typical, and the company sells at very high trailing P/E and forward P/E as well (as infinitely forward as needed to have an investor expect a profit). Typical strike price on the ESOP options is 20% of the stock price. Eligible for excercise the next year are 25% of outstanding options.
For these typical numbers the company cash flow will see:
25% of options X 20% outstanding options X 55% of Market Cap = Earnings due to ESOP excercises = 2.75% of Market Cap
If the company sells at a P/E better than 1/0.0275 = 36, it will see a great benefit from the issue of stock options, simply because its price has risen to 5 times the strike price on the ESOP options.
If the sale of puts is included, the company has a typical at the money option premium of some 20% of price and sells enough to cover most of the excercized options - bringing the total benefit of excercize to 75% of the sum taken in by the employees excercizing the stock options. This raises the benefit to the bottom line from 2.75% of market cap to 3.75% - and brings the benefitial P/E critical value down to 27.
The total benefit to future earnings from the options is 4 times the above 2.75% of Market Cap, at 11% of market cap.
The savings to the company in wages is accrued well before excercize and stands at:
20% of market cap (20% of shares is options outstanding)
X 80% (out of the money portion)
X (100% + 28%) -> the 28% is the non-wage compensation expense saved
This totals 20% of market cap.
Even a company selling at a P/E of 5 would benefit from this.
Even if the wage benefit is only half because of the employee's expectations being lower than the market's price growth expectations, there is still a 10% of market cap benefit, annually, to the bottom line.
If there is such a machine as a perpetual profit machine, then this is it - 10% + 3.75% = 13.75% of market cap growth from stock appreciation is added to the bottom line every year, 1/3 in cash, 2/3 in wage savings.
The pivot point for the P/E is then 1/0.1375 = 7.3
Even multiplying this by the dilution, 1.20, leaves a P/E of 9 as the critical point.
For the typical Nasdaq 100 company selling at 180 times trailing earnings, and 130 times expected future earnings, this creates the fulfillment of the expectations of investors pushing up the stock price.
So LINUX is free, and companies sell the doccumentation at 30 to 70 dollars a piece with a 20 dollar rebate - does the profitability of the business matter at all if they can sell the stock at 500 times Revenue? All they need is lots of options, lots of new revenue and a firendly hypester.
The cost of producing the revenue is irrelevant if the company sells much above 10 times revenue, since the ESOP plan will provide the missing profits.
In technology, the stock market is an active participant in the company's earnings. Each dollar of price rise in the shares allows for 10 to 20 cents in wage savings and 2.5 to 4 cents in next year's earnings. The company is actually a stock technology company, not a technology stock.
Steve - By buying a share of a "tech stock" you help fulfill your expectation of higher earnings in the company.
Current P/E ratios are virtually guaranteeing a steep rise in stock price, simply because of prior price rises. This is the fundumental portion of "momentum investing".
Guess what, it also works in reverse - just imagine what happens if there is an interest rate spike because the Green one is worried about the green ones losing their value. If the rise in interest rates goes from 5.5% to 10%, there would be a tendency to discount the future earnings at a lower value. If this falls below the critical P/E value that sustains this machine, the tech stocks will tumble, as will their earnings. Reversing this tumble would be very difficult. |
