The Perils of Palantir
Investor Michael Burry, best known for predicting the subprime mortgage collapse depicted in The Big Short, recently gave a rare interview in which he laid out the reasoning behind his latest short positions in Palantir and Nvidia.
One part of the discussion, focused on stock-based compensation (SBC), in particular caught our attention:
“And so, let me put it this way. There are, I think, five billionaires that came out of Palantir because they own Palantir stock, and the revenue was $4 billion or less… So the billionaires-to-revenue ratio was greater than one, and I’d never seen that before… How did they get five billionaires out of that group?”
The answer, of course, lies in the company’s compensation policy. Through lavish use of SBC, Palantir systematically transfers a large portion of the company’s economic value to insiders through equity grants.
It is commonly assumed that this form of compensation is preferable to cash payment since it aligns management with shareholders, on the theory that it encourages executives to pursue ever-higher stock prices.
But the theory is faulty. Managers do not bear the cost of those options, whereas owners do. Buffett has written extensively about this, and we won’t repeat his arguments here1. Suffice it to say that his crusade can be credited, in part at least, for the change in U.S. GAAP accounting in the mid-2000s.
The new requirement mandated that companies recognize compensation cost for share-based payment at fair value in the income statement. It is then added back to operating cash, since it’s considered a non-cash expense.
But Burry argues—and we are amazed that this is not more widely understood—that this accounting change, though better than before, still doesn’t fully reflect the true cost of options.
“What Wall Street generally does is they take the earnings per share, then they add back stock-based compensation because it’s non-cash... And I think, actually, the way GAAP accounts for stock-based compensation skews low versus what it actually costs. The real cost, you can look at how much the company is buying back to offset that dilution. And you can just take that amount and deduct it from cash flow. And so if you do that with Palantir, historically, they don’t make anything. So I basically looked at the company and said, you’re worth this much and you really don’t make anything.” [Edited for clarity]
In other words, the expense is based on grant-date estimates of fair value, which may bear little resemblance to the actual economic cost of issuing equity once the stock price appreciates (and dilutes existing shareholders). This is the cost that Buffet talks about.
To adjust for this, we can therefore do one of two things.
If share count has been mostly flat, we can assume the company’s share buybacks are offsetting the dilution and proceed as Burry suggests: take the amount spent on buybacks and deduct it from operating cash flow when calculating free cash flow. The same adjustment can be made to earnings by replacing SBC with buyback expense.
If share count is rising or falling, we need to dig a little deeper. In the Statement of Shareholders’ Equity, identify net shares issued under employee compensation plans (often disclosed as “shares issued under employee plans”) and multiply that figure by the average market price over the period.
It is a useful reminder that Wall Street often relies on shortcuts—and that careful investors like Burry actually think these things through.
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See Berkshire Hathaway’s Letters to Shareholders in years 1998, 2002, 2015, 2016, 2018.