Extremely Sloppy and Dubious Sell-Side Research

Kerrisdale Capital posted an eye-opening piece earlier this year detailing “extremely sloppy” work published by analysts at well-known banks. The focus is on “one of the most basic inputs of equity valuation: the number of fully diluted shares of common stock.”

Visit a basic finance website such as Yahoo Finance or Google and you’ll see 138.7 million shares for Service Now, leading to a market cap of about $8.1bn at the current $58 share price. You could forgive an ordinary retail investor for assuming that this information is accurate.

However, professional investors should always be aware of the total capital structure, rather than just the number of current outstanding shares, which is one of many inputs to determine valuation. In the case of young companies, particularly in technology, analysts can’t overlook stock option grants to employees. Since tech startups tend to be short on cash and long on blue sky potential, they forgo paying higher compensation in the short-run and defer it via options. Usually this doesn’t make too much of a difference in the long run, but if a company is particularly successful, and/or its shares perform exceedingly well, the impact of options grants given to executives and early-hire employees can be dramatic.

ServiceNow has more than 25 million outstanding in-the-money stock options, in addition to almost 5 million restricted stock units (“RSUs”) (2013 10-Q3). With the options having an average strike price of $8.12 and RSUs providing no future cash to ServiceNow’s treasury at all, these 30 million issued shares represent a tremendous dilutive overhang to the company’s share count. When these 30 million shares convert into common stock, the company will raise only ~$200 million in proceeds but be burdened with $1.75bn of newly traded common stock.

In reality there are 169 million shares of ServiceNow, or 165.4 million using the treasury stock method, rather than the 139 million you see reported at sites such as Yahoo or Google. And it’s excusable that these free finance sites are wrong; you get what you pay for. This is why an investor should always check a company’s filings rather than simply trusting a free website’s computer-generated financial information.

Given that the average exercise price for the options is $8, compared to a current share price of $58, and even the most recently granted round of options are still well in the money, it should be assumed that the vast majority of these options will turn into common stock as well. Thus, adding together the 138.7 million common shares, the 4.8 million RSUs, and 21.9 million dilutive impact from the options (using the treasury method), we arrive at 165.4 million fully diluted outstanding shares, which results in a market cap of $9.6bn.

If you are new to accounting / finance there is a fair amount of foreign vocabulary in the passage above. The takeaway is that, according to the commentary published by Kerrisdale, analysts are reporting inaccurate fully diluted share counts for ServiceNow (NOW). This is no trivial matter as this data is used in many critical financial metrics (you will find it referenced in models on this website). You may have noticed that the discrepancy in share count above results in two significantly different figures for the company’s market capitalization.

For the full article and a list of the institutions that reported different figures please visit the Kerrisdale Commentary page.

About Kerrisdale Capital Management, LLC

Kerrisdale Capital Management, LLC is a fundamentally-oriented investment manager that focuses on long-term value investments and event-driven special situations. Kerrisdale has $225 million in assets under management and is based out of New York City.