Stock based compensation (SBC)

Stock based compensation (SBC)

Author: Joris Kersten, MSc

Kersten Corporate Finance: M&A and Valuations @ The Netherlands (medium sized & SME deals). www.kerstencf.nl

Valuation training: 5 day training, 4th – 8th November 2024 @ Amsterdam South (Zuidas). www.joriskersten.nl

Source used: Morgan Stanley Investment Management, Counterpoint global insights. Stock-Based Compensation: Unpacking the issues. Michael J. Mauboussin & Dan Callahan. April 2023.

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Introduction

The bulk of employee compensation is in cash.

But public companies in the US are increasingly paying employees with stock, instead of cash.

So they are changing their workers into shareholders.

And this is called “stock based compensation” (SBC).

SBC can be seen as a way to finance growth.

Moreover, SBC can be seen as an incentive for employees to deliver results.

And as a tool to retain workers, and as a tool to foster overall sense of ownership.

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SBC in the P&L

SBC became more important in the 1980s and 1990s.

But then SBC was not required to be recognized as an expense on the P&L under US GAAP.

This until 2006.

Companies had to include details about their SBC programs in the footnotes until 2006.

But the expense was until 2006 not in the P&L.

Companies, especially those in the technology industry, lobbied against putting these costs in the P&L.

They claimed that this would lead to a lower stock price.

But subsequent research showed that this concern was not correct.

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SBC since 2006

As mentioned, since 2006 SBC is taken up in the P&L.

And total SBC expense in the P&L for companies in the Russell 3000 was about 25 billion USD.

The Russell 3000 tracks the largest stock in the US (by market cap).

It is estimated that SBC was about 270 billion USD in 2022.

(please see source I have used for this blog)

Or 6% to 8% of total compensation for public companies in the US.

Sales over time ( 2006 – 2022 ) went from 11.5 trillion USD to 21.1 trillion USD.

And as a percentage of sales, SBC went from 0.2 % in 2006 to 1.3 % in 2022.

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Within this perspective, it is useful to look at the “corporate life cycle”.

In general, SBC as a percentage of sales, is higher for younger companies, than for older companies.

And the use of SBC also varies greatly by sector.

Information technology, communication services and financials rely most heavily on SBC ( SBC divided by total sales ).

Subsequently, 4%, 4% and 2.3% of sales in 2022.

And SBC as percentage of sales is the lowest for the utilities and consumer staples sectors.

( less than half a percent in 2022 )

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Buybacks

Life cycle analysis also shows that returning capital to shareholders ( dividends + buybacks ) increase as companies age.

This because the older they get, the more profitable, and the more cash available.

Further, companies today pay out a higher percentage of their “free cash flow”, than companies in past decades.

Most of this growth comes from “buybacks”.

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Separately from the P&L, “cash flow from operating activities” does not reflect SBC as an expense.

But SBC is for some companies greater than “cash flow from operating activities”.

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More than 95 % of public companies now report NON-gaap results.

Adding back SBC expense (in the P&L) is a common adjustment to calculate EPS and EBITDA, as non-gaap numbers.

But buybacks that offset dilution from SBC (a non cash expense), turn SBC into a cash expense. ?

So companies should not get the benefit of adding back ( non cash ) SBC expense, without a full acknowledgement of the cost of buying back shares.

Let’s look at this a little deeper, by taking a closer look at the involved "accounting issues".

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Accounting implications

There are 2 ways to incorporate SBC into valuation that are (technically) equivalent:

1.????? Treating SBC as an expense;

2.????? Treating SBC as an employee claim on equity.

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SBC as an expense (method 1)

The key is to recognise the entries on the “statement of cash flows” that have NO "net cash outlays", but are in fact two transaction in one.

SBC and leases are the most important ones.

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For example:

1.????? Stock compensation is an operating transaction, where the employee is paid for the service;

2.????? Stock compensation is a financing transaction, where the employee is a source of equity capital.

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Another example:

1.????? A finance lease is an investing transaction, where a company buys a fixed asset;

2.????? A finance lease is a financing transaction, where the company raises debt.

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Recognising SBC, and leases, as four transactions allows the investor to calculate FCFE ( free cash flow to equity ) accurately.

?This is done as follows:

·???????? Treat SBC first as an expense, and this will reduce the cash flow from operating activities. And secondly, treat SBC as raising equity in the cash flow from financing activities;

·???????? Treat leases first as a capital expenditure (CAPEX) in the cash flow from investing activities. And secondly, treat leases as raising debt in the cash flow from financing activities.

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And this description of FCFE (free cash flow to equity) differs from the common definition of free cash flow in two ways:

1.????? Cash flow from operations is lower;

2.????? CAPEX is higher.

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But when you treat SBC as an expense, and leases in full as CAPEX, you can now project future FCFE.

You can then discount future FCFE with the cost of equity.

And then divide it by “fully diluted shares outstanding” of the ongoing shareholders.

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SBC as an employee claim on equity (method 2)

The second method does not recognise SBS as an expense:

1.????? On the income statement, and,

2.????? On the cash flow statement.

But rather considers it as a claim on equity.

And moving SBC from an expense to a claim on equity is what creates "dilution".

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So FCFE will be higher when no expense for SBC is recognised.

But this will be offset by the employee claim.

So the higher FCFE will divided by the number of ongoing shareholders + the new employee shareholders.

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Leases still needs to be added to CAPEX.

But in practise, companies that use a lot of SBC typically do not use lots of leases.

And companies that use lots of leases, do not use lots of SBC. ?

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Concerning buybacks, please note that buybacks have no impact on value per share !

Unless the shares are “mispriced” !!

Because when they are under-valued, or over-valued, then you will have a “wealth transfer”.

But at a fair value, they have NO impact on the share value.

So assuming that a company funds buybacks with future cash flow is “double counting”.

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I hope this blog gave you a better understanding of SBC (stock based compensation).

Thanks for reading,

And see you next week again with a new blog !

Best regards, Joris????

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Source used: Morgan Stanley Investment Management, Counterpoint global insights. Stock-Based Compensation: Unpacking the issues. Michael J. Mauboussin & Dan Callahan. April 2023.

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