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 ServiceNow, 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.
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