Free Cash Flow is distorting the truth

If you gave me half your business for free, there would be no cash flow impact today, but I’m sure you’d agree there’s a cost to you giving me 50% of all future profits.

Accountants record the value of “Stock-Based Compensation” (share option grants and restricted stock units - RSUs), as an operating expense over the vesting period. But since no money changes hands at the time of the grant, it is a “non-cash flow item” and therefore excluded from the calculation of Free Cash Flow (FCF.)

But since stock-based compensation (SBC) undoubtedly has a cost and also regularly absorbs company cashflow in the form of share repurchases to offset the dilution, is the standard FCF calculation not flawed if SBC is excluded?

It’s an important question because a 2016 CFA member survey found FCF to be one of the "primary metrics" being used to value companies. But because this is “non-GAAP” term, not all companies use it, and those that do, create their own definitions. Furthermore, since a significant portion of major global indices is invested in the giant technology companies which grant $billions worth of options and grants annually, if we aren’t valuing these companies appropriately, the world’s savings may be at risk.

In 2019, Amazon's SBC was 32% of operating income and Alphabet's was 24%. In comparison, SBC was only 1.8% of Coca-Cola's operating income.

To completely ignore such a material cost in your primary valuation methodology is surely folly.

Furthermore, under certain circumstances, SBC can also reduce the effective tax rate. If FCF includes the tax benefits while excluding the costs giving rise to those benefits, isn't that inconsistent?

And upon the vesting date, the value of the shares issued but withheld to pay the employee tax, is disclosed in the Financing section of the cash flow statement and not in the Operating section used to calculate FCF. That’s not how normal payroll taxes are treated.

"What then is the true free cash flow impact of shareholder-based compensation?"

It is surely the cost of returning ordinary shareholders to their original financial position before the share-based awards?

If companies grant employees share awards as part of their remuneration and then re-purchase shares on the open market to offset this dilution, then I suggest that this is the true free cash flow impact of SBC, and should be included in the FCF calculation?

In 2019 Facebook spent $4.1bn repurchasing 22 million Class A shares but they also issued 20m ordinary shares as settlement of RSU’s, so total shares only declined by 2m shares over the year. Since 91% of the shares repurchased were essentially from employees, surely the ultimate cash flow impact of their SBC was 91% of the $4.1bn spent i.e. $3.7bn?

Amazon hasn’t repurchased any shares in recent years but to offset the dilution of the 6.6m shares that vested in 2019 would have cost $11.8bn at the company’s average traded price in 2019. This is equal to 73% of the $16.2bn FCF that the company reported.

"When companies repurchase shares, are they returning cash to shareholders or returning cash to employees?"

The table below calculates 2019 FCF impact of SBC using vested shares as a % of shares repurchased and then allocating the appropriate portion of the amount spent on buybacks accordingly.

On this basis, "True Free Cash Flow" is substantially lower than the conventional free cash flow which excludes all SBC.

The move to passive funds means that an ever-increasing percentage of the world’s savings are being blindly allocated to companies without any consideration for the underlying valuation. Active managers have to assume this responsibility. The five largest technology companies have been responsible for 80% of the performance of the MSCI World Index over the 3 years to April 2020, and are now worth a combined $5.4 trillion. Other than Microsoft, the outlook for the group is so uncertain that no guidance has been offered for 2020 and yet they are trading at very low "true free cash flow yields" when adjusting for SBC. As the bursting of the dot-com bubble and housing crisis demonstrated, a sensible allocation of capital is in the best interests of society.

Having an accurate valuation methodology is a good place to start.

Therefore, there is an urgent need by the International Accountancy bodies, regulators and the CFA Institute to improve and standardize the use of the term “Free Cash Flow” in order to better present reality. I call on them to do so.

Sean Peche is the portfolio manager of the Ranmore Global Equity Fund Plc which has no direct or indirect holdings or positions in any of the companies mentioned.