The use of stock based compensation has grown over the last twenty years, not just among the CEOs and other C-suite management but also among the lower tiers of employees. As many of the newer companies become public, the increase of stock-based compensation continues to grow.
It makes sense when you think about it; enticing employees to work harder or stay longer is a smart way to go about rewarding employees. And treating employees as owners by giving them a stake in the company encourages better performance.
But the growth of stock based compensation is not without some controversy, which we will cover in the upcoming post. Many of the top minds in valuation differ on the accounting treatment of stock based compensation expense and its impact on its value.
“Never, ever, think about something else when you should be thinking about the power of incentives.”
In today’s post, we will learn:
- What is Stock Based Compensation?
- Why is Stock Based Compensation an Expense?
- Controversy Around Stock Based Compensation Expense
- Investor Takeaway
Okay, let’s dive in and learn more about stock based compensation expense.
What is Stock Based Compensation?
In simple terms, stock based compensation is the method of a company paying employees with shares. The company uses stock options as the vehicle to transfer the shares to the employee.
Often, the shares are a reward for outstanding work; in other cases, it is a means of enticing employees to remain with the company or reward them for their longevity.
It is also known as Share-Based Compensation or Equity Compensation.
The method is a way to pay employees, executives, and directors of the company with equity. The most common use of stock based compensation is a reward beyond their regular pay, salary, and bonus. It also helps align the employee’s interest with those of the shareholders, like us.
The shares typically tie to some vesting period before the shares are earned or sold for cash.
Equity-based compensation comes in a few different flavors; here are some common flavors:
- Restricted Share Units (RSUs)
- Stock Options
- Phantom Shares
- Employee Stock Ownership Plan (ESOP)
RSU – Restricted stock or RSUs are shares employees can receive for hitting performance goals or sticking around a certain number of years. They require a certain vesting period, which will vary by company, and they can get all vest at one point in time or over the years, or they can drip them at a set amount over a period. Many CEOs receive a large part of their pay in this method.
Stock Options – stock options give the employee the right but not the obligation to buy shares of the company at an agreed-upon date and price. The employee’s advantage is they can exercise their rights when it works best for them, after the vesting period.
Performance Shares – many companies reward upper management with shares for targets completed. Items such as earnings per share, return on equity, or the company’s return compared to competitors.
Employee Stock Ownership Plan – These types of compensation allow employees to buy shares in a simple, easy way using after-tax payroll deductions. Another benefit of these plans is that they allow the employees to buy the shares at a discount, encouraging more participation.
Today, most businesses use this form of compensation to reward their employees. The shares typically vest after few years, in many cases, three years. What this means is the employee does not earn that value until the three years pass. If the employee leaves the company before the end of the vesting period, they lose those shares. On the other side, if the employee stays through the vesting period, they receive their shares. Once the vesting period is over, the employee has the choice to hold the shares forever or sell them and take their cash.
When I worked for Wells Fargo, they had an employee match program through our 401k that allowed us to buy shares of the company at a discount, but they didn’t achieve full value until we had worked there for three years.
After three years, the shares were issued to me at full value. If I left before that period, I would only receive the partial value of the shares. So, it worked on a sliding scale, for example, on a $50 share price:
- One year – $25
- Two years – $35
- Three years – $50
Why is Stock Based Compensation An Expense?
From an accounting case, stock based compensation is an expense and removes itself from its earnings. The stock based compensation expense is part of the operating costs of a business.
As I mentioned above, there is some controversy about the accounting of this employee benefit, more on that in a moment.
In accounting terms, stock based compensation expense is a non-cash expense, and in the cash flow statement, accounting adds back the expense to operating cash flow. Similar to depreciation and adding it back to improve the operating cash flow because the cash expense is not “actually” paid out.
Let’s look at an example from the cash flow statement of Facebook.
As we can see from above, Facebook issued:
- $6.5 billion in share based compensation in 2020
- $4.8 billion in share based compensation in 2019
- $4.1 billion in share based compensation in 2018
From an income point of view, the expense for share based compensation is in any of the costs of revenue or operations; below are a few excerpts from Facebook’s latest 10-k 2020 to outline how the company accounts for this expense.
From the above excerpt, we can see scattered throughout that the expense is in about different line items from the company, and it helps encourage performance and pay Facebook’s employees.
Below is a breakdown of each line item from the income statement and how their share based compensation impacts each sector of the business. A note about the below chart, not all companies break it down that granularly, which is nice to see. As a tech company, you would expect to see R&D as the largest recipient of share based compensation because the new tech drives a company like Facebook.
Next, we see from the 10-k how the company has an Incentive Plan authorized by the board of directors for Facebook. This shows us how much of a part of the compensation it is for Facebook, which helps them attract top talent.
As we work through the accounting of share based compensation, we should probably talk about a few of the benefits and disadvantages.
A few advantages for the company:
- Creates incentives for employees to help improve performance and encourage continued employment with vesting time frames.
- Aligns shareholders and employees’ interests, both working towards prosperity and a rise in share price and value.
- It doesn’t require cash upfront for the company to hire and retain top talent. Those shares can rise quite quickly in value, creating a lot of wealth for the holder of the options.
A few disadvantages for share based compensation:
- It dilutes the ownership of existing shareholders by increasing the number of shares outstanding.
- If prices are falling, the ability to attract talent diminishes because there is less value in the long-term.
Another benefit for the company that isn’t discussed much is the impact on the taxes of Facebook, for example.
“excess tax benefits recognized from share based compensation decreased our provision for income taxes by $656 million and our effective tax rate by two percentage points as compared to the tax rate without such benefits.”
The company also mentions later that if the share price falls below the share-based compensation grant price, the tax rate will increase.
So, there is a most definite benefit to Facebook on the tax front, increasing its bottom line.
While the expense doesn’t require cash upfront, it does increase the shares outstanding, which drives down the earnings per share.
The above picture outlines how the increase in shares outstanding impacts the company’s earnings per share, affecting the company’s share price because Wall Street focuses intensely on earnings.
The Controversy Around Share Based Compensation Expense
Before uncovering some of the controversies around this expense, let’s look at the history a bit. In the early 1990s, young tech companies with major cash flow issues started accelerating the idea of issuing share-based compensation to attract employees.
Some of the accounting rules around the expense allowed companies to grant stock options to employees and show no cost by adding back to cash flow as a non-cash expense. Not surprisingly, companies treat the stock options like free money and pass it around like candy, especially top executives.
When the options are exercised later, the companies report a large extraordinary expense, illustrating the disparity between Facebook’s price at the time of granting shares and exercising the shares. And not to mention the impact of taxes, as we explored with Facebook.
After twenty years, share based compensation is now a permanent part of the corporate world, but there remains a lot of confusion.
For the next discussion, I want to use the words of Professor Damodaran:
“1. Is it an expense?
This is an easy one. Of course! If you look at why and where companies use stock-based awards, it is more used early in a company’s life cycle, and it is used to compensate employees. As Warren Buffet is famously quoted as saying, “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses should not go into the calculation of earnings, where in the world should they go?”
The timing of the expense is also clear. It is at the time of the grant, and arguments that use uncertainty about whether these options will be exercised in the future to justify not expensing them are specious. We are uncertain about almost everything that has to do with the future, but that does not stop us (or should not stop us) from making our best estimates at the time that we encounter them.
2. Is it a capital or operating expense?
This is trickier, since it really depends upon who gets the options and what function they play at the company in question. In the case of Twitter, for instance, the bulk of the options were granted to employees in the R&D department:
An argument can be made that R&D expense is a capital expense, not an operating one, and that it should treated as such. I concur with the sentiment (though I don’t know the classification system that Twitter used to determine the breakdown of stock-based compensation). And I did capitalize R&D expenses in my Twitter valuation. However, that does not give you a license to just add back the expense, since capitalizing it will result in an asset that has to be depreciated; see this paper that I have on capitalizing R&D, if you are interested. Thus, if Twitter wanted to use this rationale, it should have added back just the R&D portion of the stock-based compensation and then subtracted out the depreciation on the synthetic asset it creates.
3. Is it a non-cash expense?
Many equity research analysts seem to think so, but then again, their judgment on a number of fundamental valuation issues remains questionable. Let’s be clear on what it is not. It is not an expense like depreciation, which is truly non-cash and should be added back to get to cash flow. It is closer in spirit to an in-kind compensation than a non-cash compensation. To explain my reasoning, let me use an analogy. Let’s assume that you own and run a business that has an overall value of $100 million and generates $10 million in annual income. Let’s assume that you hire me as your manager and that my compensation is $1 million and that rather than pay me with cash, you give me 1% of the business as compensation (1% of $100 million is $ 1 million). While you may maintain the fiction that this is a non-cash expense and that your income is still $10 million, you are now entitled to only 99% of that income in perpetuity. In effect, your share of the business is worth less and it will get even smaller over time, if you continue to compensate me with equity.”
He expresses the ideas far more eloquently than I ever could, and I think he lays out his ideas quite well. The basic gist, the share-based compensation impacts the company’s value, and as an analyst or stock picker, we need to account for that impact.
Another great stock valuation expert, Michael Mauboussin, has shared different papers that discuss share-based compensation and its impact on companies’ value.
He pointed out in a recent paper that:
“Stock based compensation ends up being 15% to 20% of cash flow from operations, and for the S&P 500 tech sector, and the smaller businesses, the worse that share based compensation expense impact is on the company.”
Beyond the valuation, the impact is the misalignment of incentives, such as the explosion in share based compensation in CEO salaries. The increase in stock based compensation has lead to an increase of sketchy behavior from some leaders of extremely large companies.
For example, McDonald’s, Caterpillar, and Boeing recently got in some hot water because the former CEOs were doing a little game with accounting to manipulate share prices and increasing those prices with the granting of excessive stock options. Then they manipulated the earnings to juice the share prices and cashed out their options, becoming rich while diluting earnings for shareholders.
Shady stuff and they were found out and subsequently fired, but they had their golden parachutes already exercised.
But the outcry about the exorbitant CEO salaries stems from the issuing of share based compensation and the value of those shares.
Charlie Munger has spoken many times about the power of incentives, and he has some pretty fantastic ideas that help explain why we do some of the things we do. Check out this article that outlines Charlie’s ideas.
As an analyst or stock picker, when using a discounted cash flow to value a company, we must decide what to do with the share based compensation expense. Depending on your view on the expense, you add it back to the company’s cash flow, which will grow your valuation. Or you can also follow Professor Damodaran’s idea and exclude it from the earnings or cash flows, which will decrease your company’s value.
We need to account for the outstanding balance of share options; consider that they currently have a balance of $16.3 billion of share options outstanding in the case of Facebook. That is a real cost in cash when employees exercise their options.
To account for this claim on the company’s equity, we need to net out this value from the company’s equity and next divide it by the actual shares outstanding, not the diluted shares.
It might seem we are double-counting the value of the options by reducing it from the earnings or cash flows and reducing our company’s equity. But we are not because if the company stops issuing share based compensation at some point, we can stop reducing the impact on earnings. And then, after exercising all the shares, we can stop the reduction of equity.
The outcome of all the accounting and decisions we make when valuing a company regarding share based compensation expense is the lowering of the company’s value. In effect, it is another way of creating a margin of safety if our guesses are way off.
Next up, how to value the stock options and use them in a discounted cash flow.
And with that, we will wrap up our discussion for today.
As always, thank you for taking the time to read this post today, and I hope you find something of value in your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,