Stock Based Compensation (SBC): Feature or Bug?
Thoughts on SBC
WARNING: This will not be the most exciting post I’ll ever write (luckily it’ll be fairly short!)
A topic that generates heated controversy and polarising views is Stock Based Compensation (SBC). Tech focused investors describe it as a necessary feature required to attract top talent, while more old school value investors perceive its use as sometimes egregious and over the top.
The objective of this short note is to clarify my own thoughts about SBC especially given my two somewhat conflicting views:
Some of the better quality companies out there do issue a lot of SBC (and will continue to do so;
I abhor getting diluted as a shareholder
For those unfamiliar with the basics of SBC, refer here.
First Principles
The purpose of fundamental equity analysis is to derive as informed an idea about the economic realities of a business as possible. Over the long run this comes down to the free cash flow available to all equity holders that a business generates. This may or may not be reflected in accounting statements.
Note, the key metric to monitor is growth in economic value per share. The per share part is extremely important in this discussion as if my stake as an equity holder keeps being diluted in line with growth in the firm’s economic value, the value of my investment does not move in line with firm value. The below is an extreme example but illustrates the point clearly.
My view: SBC is a very real expense and must be accounted for as such. I don’t see any other way you can look at it. But if my view is of little use to you, I’ll leave the last word to the GOAT himself.
“If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?”- Warren Buffett, 1992 Berkshire Letter
GAAP Accounting treatment of SBC
Income Statement: SBC is recognised as a non-cash expense on the income statement and allocated to relevant opex lines:
SBC issued to direct labour is allocated to COGS
SBC to R&D engineers is included within R&D expenses
SBC for management and those involved in selling and marketing is included in SG&A and other opex
Note, the consolidated income statement will not explicitly break out SBC on the income statement (see image below), but most companies provide segment level disclosure in the footnotes.
Cash flow Statement: SBC is added back to cash flow from operations as its technically a non cash expense.
Financial Statement Adjustments
It’s worth noting that estimating the impact of SBC ex-ante is extremely difficult to do. However, I’d argue it’s an exercise worth doing given that valuation in and of itself is an imprecise art, and it’s a much better alternative than ignoring these very real costs to a business.
There are broadly two types of SBC impacts that equity investors deal with:
SBC issued in the past- Vested or unvested
I tend to be conservative with this and account for all unvested dilutive securities (in the money options and restricted stock units) in my diluted share count.
The rationale is if you’re considering an equity investment with material amounts of SBC, your model will assume growth in both operating metrics and the share price. Therefore it is only reasonable to assume the bulk of unvested RSUs/Options will vest.
SBC to be issued in the future- Free Cash Flow calculations are overstated
Under GAAP accounting, SBC is added back to net income to derive a cash flow from operations number. However, not all non cash charges are equal. Most well known non cash items (e.g. depreciation) will have either triggered a cash flow event in prior periods or will do so in future periods. This is not the case with SBC.
SBC is more accurately seen as two simultaneously occurring transactions.
An operating transaction where the employee is a provider of services
A financing transaction where the employee is a source of capital
As such, I believe a more accurate representation is to treat SBC as a financing cash inflow rather than an add back to operating cash flow.
“We have to hold equity compensation to a different standard than we do non-cash expenses like depreciation, and be less cavalier about adding them back.”- Aswath Damodaran
For these purposes let’s assume a basic free cash flow calculation of:
FCF = (Cash Flow from Operations - Capex)
In this scenario, FCF is overstated by the amount of SBC expense. Correctly adjusting for this (no matter what method one uses to calculate FCF) has a material impact on any serious valuation exercise.
A basic scenario is illustrated below to demonstrate the valuation delta that can occur. Clearly as the level of SBC ramps up, this delta will also increase.
The Verdict
So is the issuance of SBC a feature or a bug? Like anything, the answer is subjective and company dependent, with context needed to fit in with the broader narrative of one’s analysis.
Issuing SBC attracts high quality talent that can get a growing organisation off the ground in a way that otherwise would not be possible.
On the other hand, there are prevalent examples today in the tech world of this practice being egregiously used and shareholders being misdirected to focus on meaningless metrics that don’t portray the true economic reality of an enterprise.
It is our job as equity analysts to see through this noise and form our own conclusions.
superb