Over time, I’ve collected notes from various books and articles of odd corporate practices. Everyone else seems to think these various practices are “normal” behavior but I can’t help wondering if they are examples of businesses and investors going off the rails. Below are four different areas that have puzzled me over the years.
Corporate Charity vs Taxation
When an institution takes money from Person A and gives it to Person B, it’s called taxation. When a corporation does it, it’s called charity.
How else can you describe a situation where a corporation decides unilaterally to make a donation out of what is clearly owners’ profits? Take for example these corporation that have donated over $1 million to Hurricane Harvey relief efforts. Doesn’t it seem strange that management decided who gets the donation and how much? Didn’t the money belong to the shareholders and were they consulted before the donation?
I promise that I’m not heartless! It’s a real conundrum, given that I support these donations and would probably vote for them as a shareholder. I just find it odd that the corporation’s managers get to decide who and how much to give. It seems like it should be a decision for the owners to make since, after all, it’s their money.
This is particularly troubling when you imagine the effort charities must go to in order to court management to make donations. Aren’t the company’s management benefitting from the connections and prestige that comes from making multimillion dollar gifts to organizations?
EBITDA and Cashflow
EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. It’s a widely used accounting method meant to make it easier to compare different businesses since you ignore the different methods of financing (interest), jurisdiction (taxes), amount of assets (depreciation) and previous takeover histories (amortization of goodwill).
So, in other words, EBITDA ignores all the costs associated with the actual business. Does that sound helpful? Is anyone seriously making an argument that interest doesn’t have to be paid? Or that assets aren’t depreciating? And is the Easter Bunny paying everyone’s taxes out of a magical basket?
I remain baffled at how EBITDA is a helpful tool for an owner or prospective owner. I’m quite confident those ignored costs will have to be paid before I get paid, so knowing a company’s EBITDA is about as useful as knowing that a job pays $100,000/year without knowing where I’ll have to move, what gear I’ll have to buy and what taxes I’ll have to pay in order to achieve that income.
I can’t remember where I heard it but basically a company will report numbers like this: (1) income; or (2) if no income, EBITDA, or (3) if no EBITDA, revenue; or (3) if no revenue, a large user base; or (4) if no users, by its venture capital investments; or (5) if no venture capital, by the strength of the owners’ backgrounds.
Not all earnings are created equal.
Stock Splits as a Way to Increase Value
From time to time, a company will decide that the price of a single share has become too expensive and will engineer a stock split. Thus, a single share of a stock trading for $400 will suddenly be split into four shares trading for $100 each. It doesn’t take a mathematical genius to realize that no value has been created by the split. This hypothetical investor still owns $400 worth of the company’s equity.
So why split the stock?
Because it seems to encourage increased trading.
Unfortunately, this does nothing for the individual owners except hand over part of the corporate pie to the brokers making money during each trade. If a company feels compelled to split its stock to achieve smaller and smaller share prices in order to attract investors, it’s clearly only attracting owners that are purchasing the stock for non-value reasons. The more non-value owners that a company can count in its shareholder base, the more likely the stock price will fluctuate based on speculation as those owners dash in and out of the company.
Who would want those owners? As a fellow owner, I don’t see any benefit to having them on board with me. I’d much prefer they focused on a different penny stock to play out their get-rich-quick scheme.
I can’t see any reason for stock splits. The best argument seems to be that such activities increase things like “liquidity” and the rational ability to allocate capital most efficiently. I find this argument weak. Stock splits only seem to encourage hyperactive and unnecessary frothy markets. It’s also arbitrary. If stock splits really were needed to make the market function efficiently, every company should continue splitting the stock until all share prices are equal to $0.01.
Stock Options and Diluted EPS vs EPS
EPS stands for earnings per share and is supposed to be an easy mechanism for understanding how much of the earning pie is attributable to your particular ownership sliver in the company.
Therefore it’s pretty important to understand both sides of the fraction to make sure you have an accurate EPS. The numerator represents the earnings of the company. As discussed above, this better not be EBITDA or you’ll be in for a shock once some conveniently forgotten costs are eventually paid!
The denominator is equally as important. It represents the base over which you distribute the earnings. You’d think you would want to include the entire base in the denominator but often you’ll see a denominator that conveniently leaves out the people that own interests convertible into equity like stock options or warrants.
Even Wikipedia defines the term Diluted EPS as (emphasis mine):
“Diluted EPS indicates a “worst case” scenario, one that reflects the issuance of stock for all outstanding options, warrants and convertible securities that would reduce earnings per share.”
A worst case scenario? It’s as if all those stock options, warrants and convertible securities have no value because they don’t represent cash. I have an idea for management. Instead of paying me dividends each year, why don’t you issue stock options to each investor? Your EPS will stay the same while my ownership percentage of the company increases!
The reality is that stock options do have value, which is why management loves to issue them to “align interests”. Even more absurd, it’s not a worst case scenario that calls for using diluted EPS, it’s the best case scenario. As an owner, I want to know that those stock options are in the money and worth exercising because it means my investment has increased in value. A worst case scenario would be if management decided not to exercise its options because the strike price was higher than the market price. Not using a diluted ownership base when calculating your earnings is pretending that you own more of the company than you do!
Let’s talk about it. What are your thoughts on these strange behaviors in the market? Are there any others that you’ve noticed during your investing years?
Joshua Holt is a practicing private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Personal Capital keeping track of his money. He's also exploring real estate crowdfunding platforms like Fundrise which are open to both accredited and non-accredited investors.