Stock Based Compensation: A Silent Value Killer ?
Navigating the Crossroads: Unveiling the Impact of Stock-Based Compensation on Corporate Value
In the dynamic realm of modern business, the age-old adage "a fair day's wage for a fair day's work" resonates as strongly as ever. Recognizing the innate human desire for both acknowledgment and allegiance, companies have traditionally upheld the practice of compensating their workforce through regular monetary salaries. However, the landscape of employee recognition is undergoing a transformative shift, as organizations increasingly intertwine their fortunes with those of their employees by extending the allure of stock-based compensation (SBC). This transition signifies not only a nuanced approach to incentivizing hard work and loyalty, but also introduces a captivating conundrum: does SBC stand as a silent value booster or an inconspicuous value eroder?
SBC is a form of employee compensation where a company offers their employees equity in the business via stocks/ stocks options. This allows employees to buy a specific number of shares at a pre-determined price after a certain period of time, which is called the vesting period.
Using SBC as a form of employee compensation comes with a multitude of advantages. SBC allows for cash conservation. When choosing to pay employees with equity and not cash, the company can thus use the remaining cash for over value creating initiatives such as sales and marketing or even hiring more employees.
SBC also boosts and improves employee retention. When employees are given stock options, they can not exercise those options for a certain period of time which is usually 4 years: that time period is called the vesting period. This vesting period encourages long term commitment from employees.
The most important and value creating advantage of SBC is that it aligns employees interests with those of shareholders. Shareholders and employees will have one goal for the long run: which is to increase the businesses intrinsic value and hence the share price.
So far so good. Then why does SBC stir up so much debate?
Now lets get into some disadvantages of SBC, starting with the most obvious which is shareholder dilution. Dilution occurs when the the ownership percentage of existing shareholders is reduced due to the issuance of new shares as part of the compensation package. When employees exercise stock options or receive shares, new shares are introduced into the market, effectively spreading the ownership among a larger pool of shareholders.
The second is the way SBC is accounted for. It was only in 2006 when the FASB required that stock based compensation be recorded as an expense in the income statement, which we applaud. The issue is how SBC is recorded in the cash flow statement, more specifically in the cash flow from operations section.
Value investors are inherently attuned to emphasizing free cash flow, which serves as a paramount metric in their analysis. A widely adopted formula to compute free cash flow involves subtracting capital expenditures from cash flow from operations. However, a notable concern arises regarding how Stock-Based Compensation (SBC) influences the calculation of cash flow from operations.
FCF=CFO-CapEx
When calculating cash flow from operations, SBC is added back. This is because SBC is a non cash expense. SBC being a non cash cash expense does not mean it not a real expense, thus adding it back in the calculation is a con. The adding back of SBC thus skews our FCF calculation and hence our valuation analysis.
Lets look at Palantir. In 2022 Palantir spent a whopping $564 798 000 on SBC. Its cash flow from operations totaled $223 737 000( this is with SBC added back). However if we remove SBC from the cash flow from operations figure , Palantir now has cash flow operations of -$341 061 000.
FCF= CFO - CapEx
1.With SBC added back
FCF=$223 737 000- $40 027 000
=$183 710 000
2.Without SBC added back
FCF=-$341 061 000-$40 027 000
=-$381 088 000
Well well well. Now we see why some companies make sure to always add back SBC. If we do not add back SBC when calculating Palantir’s FCF, Palantir’s’ FCF goes from being positive to being negative.
What should be done to fix this?
SBC must be moved from the cash flow operations sections to the cash flow from financing activities section. How a business decided to pay its employees, via cash or equity, in itself is a financing decision. Once SBC has been moved to the financing activities section, it is no longer added back to to the cash flow from operations calculation thus it no longer affects the free cash flow calculation.
Most young and tech companies are SBC heavy. Does this mean they are all destroying value?
No.
Then how do we know if SBC is destroying or creating value?
By looking at FCF on a per share basis. Marcelo Lima, a hedge fund manager, wrote a piece on SBC, titled SBC: Friend or Foe. He pointed out that even though that Salesforce has a median SBC as a percentage of FCF of 46% it has still performed well over the long run because it has been able to compound it’s FCF per share at about 29%.
In conclusion, Stock-Based Compensation (SBC) stands as a multifaceted tool, offering advantages such as aligning employee interests and fostering a sense of ownership. However, a central challenge resides in its accounting treatment. Investors must exercise vigilance, recognizing that while SBC does not directly impact cash flow, it does wield a substantial influence on equity value and dilution. Hence, to ensure a precise evaluation of a company's performance, it is imperative for investors to meticulously exclude SBC from free cash flow calculations. This practice safeguards against potential misconceptions, allowing investors to accurately gauge a company's genuine financial health and prospects.
Done.
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