Accounting for stock based compensation expense can be tough because the numbers don’t always line-up from the income statement to the cash flow statement.
Also, depending on which Free Cash Flow formula you are using (FCFF or FCFE), your formula may automatically include the impacts of stock based compensation (FCFF) or will automatically exclude it (FCFE).
We need to understand how stock based compensation (or SBC) expense impacts real FCF to owners because over the long term its effects will compound.
And with seemingly more and more technology companies looking to attract top talent through stock options like RSUs, the impact of SBC to the long term cash flow of a business may become increasingly important.
I’m going to try and make this as simple as possible, but we’ll need some structure:
- What is Stock Based Compensation Expense?
- How is SBC Calculated in a Company’s Financials?
- Why You Should NOT Add Stock Based Compensation back to FCF
- Issued, Vested, and Unvested Stock
- Average Stock Based Compensation Percentage by Industry [S&P 500]
Hopefully after reading this post you will learn the exact ins-and-outs of stock based compensation and how it potentially impacts how you see company valuations.
What is Stock Based Compensation Expense?
First, we have to know that SBC is not something we can just ignore just because it is a “non-cash expense”.
The fastest and simplest way to find stock based compensation expense for a company is in its cash flow statement, under the Cash from Operations section. Here’s an example from Oracle’s latest 10-k:
You can see that stock based compensation is added to cash flow from operations, and because some analysts compute FCF using the cash flow from operations, it shows up as an addition to FCF.
This version of FCF should also be recognized as FCFE (free cash flow to equity), and is often simplified to:
FCFE = Cash Flow From Operations – Capital Expenditures
The reason that non-cash expenses like Depreciation and Amortization and Stock Based Compensation are added to Net Income to create Cash Flow from Operations is because these expenses don’t represent literal cash coming from a business.
Remember that Depreciation expense is an accounting measurement trying to smooth out large capital investments in the income statement (which also works for tax purposes).
A company may very well have to burn significant cash flow in a given year to build a factory for example, but in the years to follow there will be little cash outlays for that plant. But from the income statement side, that cash outlay is spread as an expense over many years rather than just one, so that the impact of a large investment doesn’t mis-represent the true consistent earning power of a business.
Stock based compensation expense is similar but different. A company can issue shares to pay its employees as bonus compensation, and this does not come out of cash from the business.
Instead, shareholders are essentially footing the bill to compensate employees inside the company. Often SBC doesn’t make up a big portion of FCFE, and so its dilution effect to shareholders is generally close to nil.
And many stock options which are granted/vested will be accounted for in (diluted) shares outstanding, which is why there is basic shares outstanding and diluted shares outstanding which are used to calculate basic EPS and diluted EPS respectively.
The sticky part about SBC is that certain stock options will be accounted for in diluted shares outstanding while certain other ones won’t.
Depending on the company, this can make a big difference in dilution to shareholders, which affects the real cash flows available to shareholders over the long term, and can affect total return.
As the great Warren Buffett once said about SBC:
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?
How is SBC Calculated in a Company’s Financials?
Warren Buffett’s great quote occurred during a time when the idea of adding stock compensation as an expense to the income statement was being debated.
Today, that controversy is largely over, and we have some effects to financial statements from it.
Here’s how SBC shows up in a company’s financials today.
- Income statement
- Cash flow statement
The bottom line is that you should see stock based compensation expensed in a company’s income statement, as a part of the calculation for Gross Profit or Operating Profit, and then it is added back to the Cash Flow Statement under Cash From Operations like we discovered above.
Take Google as an example. Here’s a quote from their latest 10-k, explaining how they account for stock based compensation in their footnotes on accounting policies for the 10-k:
This tells us that the company includes SBC in their income statement as part of Cost of Revenues (also called “Cost of Goods” with other companies), and so it will affect Gross Profit and Gross Margin.
We also see if you continue to scroll down the accounting policies that Stock-Based Compensation gets its own section, with information that the expense (for RSUs) is recognized using the “straight-line attribution method”, as well as additional information on PSUs.
If you’re unclear on some of the basic forms of SBC’s, such as RSUs and PSUs, I’d highly recommend Dave’s post on locating share based compensation in the 10-k, which really brings a great introduction to this whole topic.
Going back to Oracle, they also provide interesting details on their SBC expense through the notes to the financials, actually breaking it down by operational category:
Checking with the way that the company reports its income statement, we can see why they’ve classified it like that:
That these SBC expenses are included in operating expense categories like Research & Development and Sales and Marketing implies that some of their Stock Based Compensation expense is part of Operating Expenses rather than only Cost of Revenues or COGs (like Google’s was), showing that there’s probably some flexibility on how companies choose to report SBC for GAAP purposes.
Again, though calculated as an expense in the income statement, SBC does not describe real cash from a business, so it gets added back in the cash flow statement.
These two statements, the income statement and cash flow statement, should in theory reconcile from year-to-year—but many companies won’t disclose SBC as a line-item on the income statement which makes it hard to double check.
Why You Should NOT Add Stock Based Compensation back to FCF
Returning back to the financials, the reason that stock based compensation can often be forgotten is because it can often get lost with the other moving pieces of the cash flow statement.
However, just because the direct cash effect of SBC is vagaue doesn’t mean it’s non-existent.
This fantastic post by a writer from Wall Street Prep argues that point, stating:
Investment bankers and stock analysts routinely add back the non-cash SBC expense to net income when forecasting FCFs so no cost is ever recognized in the DCF for future option and restricted stock grants. This is quite problematic for companies that have significant SBC, because a company that issues SBC is diluting its existing owners.
Professor of Valuation Aswath Damodaran also teaches that this real cost to shareholders should be reflected in a valuation model estimating free cash flows, and that SBC should NOT be added to Net Income in order to reach FCFE.
In other words, SBC expense should be subtracted from Cash From Operations instead of allowed to stay in when calculating FCFE from the Cash Flow Statement.
However, you don’t have to do anything with SBC expense when calculating FCFF (great guide about the FCFF formula here).
The reason why you don’t have to worry about stock based compensation expense in a FCFF calculation is because remember; it is already included in the income statement.
Recall the Google and Oracle examples; one company had SBC expense as part of Cost of Revenues and the other as part of operating expenses. Since FCFF is generally calculated by starting with Operating Income and moving to NOPAT, etc; the FCFF formula will account for SBC expense, in effect including it in the FCF equation by including its dilutive effects through Operating Income.
Issued, Vested, and Unvested Stock
One additional key detail about stock based compensation expense is that not all of the SBC expense in the cash flow statement represents the total potential dilution to shareholders.
There are several categories of stock options/RSUs/stock compensation at any given time:
- Stocks issued (this year) but not yet vested
- Stocks issued (this year) and vested, but not yet granted
- Stocks issued (this year), vested, and granted
- Stocks issued (previous years) but not yet vested
- Stocks issued (previous years), and vested, but not yet granted
- Stocks issued (previous years), vested, and granted
I’ll be frank that the differences in accounting between the various types of stock based compensation shown above and any additional classifications are above me at this time.
According to that same Wall Street Prep article, SBC expense in the cash flow statement represents stocks issued and will be reflected (as potential dilution) in the future. Additionally, a deeper look into the footnotes of financials should uncover additional information about the number of shares that are granted, issued, vested and unvested, etc for a given company.
In theory you should include those additionally issued stocks which aren’t already included in diluted EPS into shares outstanding for FCF.
In practice it can be difficult.
From what I’ve seen, companies tend to expense SBC over a straight line, implying a spreading out of the expense over multiple years. Because you have a constant stream of old stock options and newly issued stock options, all expensed and/or diluted at different times, it can get additionally messy.
Getting the stock based compensation expense data in the footnotes to reconcile to the stock based compensation line in the cash flow statement can be difficult if not impossible because of this factor among others, making it difficult if not impossible to “check your work”.
Thus I’m hesitant to advocate including the possibility of vested and unvested shares outstanding in addition to subtracting stock based compensation from FCFE.
That’s not to say that you shouldn’t, or that there isn’t a reliable way to do it. Just that for me, being approximately right is better than precisely wrong, and subtracting SBC expense from FCFE should get most of the dilutive effect of that expense to shareholders.
That said, I don’t think there’s much of a sound argument for not subtracting SBC from FCFE.
True there is not a “real” cash draw from the operations of a business when it issues stock as an incentive for employees, especially if it takes multiple years to vest.
However, shareholders are paying for it out of free cash flows one way or the other.
Though it might not take “real cash” from operations, it most certainly must take “real cash” from financing activities.
Because some companies do massive stock buybacks, you might not see the impacts of the dilution of SBC expense because the amount of stock bought back is so much greater than that issued for employee bonuses.
At the same token, a company’s stock price can fluctuate between when they buyback shares and issue them, making the actual “cash drain” greater or worse depending on how they handle both parts.
And finally, you can certainly see when a company issues those shares and receives the cash in the income statement, which makes its way to diluted shares outstanding, which can be offset by stock buybacks (conversely, shares repurchased for stock-based compensation can show up as its own line-item in the cash flow statement under financing activities).
Regardless of where stock based compensation expense comes out from, whether through an increase in diluted shares outstanding or through cash spent in financing activities to buyback those shares, those are real dilutions to shareholders which represent cash obligations that never make it back to the owners.
In other words, SBC expense represents cash that is not really “Free Cash Flow”, defined as the stream of cash attributable to shareholders.
Whether you’re trying to mitigate the effect of SBC expense as it has caused dilution now or is likely to cause in the future, having some method to account for it in a free cash flow estimate should be a priority particularly for companies with larger percentages of stock based compensation expense compared to its Cash From Operations.
Average Stock Based Compensation Percentage by Industry [S&P 500]
Just as a bonus, I’ve included some data on the average Stock Based Compensation expense percentage compared to Cash From Operations for the S&P 500 over the last 10 years, from 2011-2020. Note that like my other historical datasets, for ease of research this includes only the current constituents of the S&P 500 and not past ones who have dropped off.
Here’s charts showing both the averages for the entire market by year, as well as by sector and industry by year:
It seems that the sweet spot for SBC expense / Cash from operations has been 4% (median), and isn’t not appreciating enough to be a noticeable trend, which I found surprising.
It also implies that if you’re not including stock based compensation expense in your estimates of intrinsic value, you’re likely overestimating true value by at least 4%.
And finally, if a company you’re investigating is much higher than this 4% mark, then the dilutive effect of SBC expense should be more closely examined than how you would with the average company.