Thoughts on Share-Based Compensation
“If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”
-Warren Buffett, 1992 Berkshire Hathaway Annual Report
Since the GOAT thinks of everything, it is not surprising that he long ago recognized how maddening this topic was. For more than two decades a debate raged about where SBC should show up. Companies fought and lobbied hard against FASB, arguing that stock-based compensation should not be included as an expense. It led to many abuses in the dotcom era where all levels of a company received rewards in stock and options. As long as the price went up, everyone seemed happy with seemingly little cost to the company. Of course this can and did sometimes end very badly when a company unraveled or experienced significant price declines.
Eventually though the pro SBC expense side won in 2006 and with FAS 123R, companies must regard SBC as compensation and expensed to net income. While in many ways it was a victory for investor protection, to force management to recognize that SBC is still a genuine cost, it is still quite strange and difficult to incorporate into the valuation of a company. After all, often no cash even exchanges hands and even if it is effectively an expense, it sure does not look like any normal expense. This was the strongest argument made by opponents to FAS123. How can something with no direct cash impact be considered an expense? How can you even record it?
Ignore it?
One way to value a company with SBC is to simply ignore it. Since often no actual transfer of cash ever actually occurs, we add it back to net income or take it out when using cash from operations. Then we do a DCF or however we value the company and say “the intrinsic value of the company has nothing to do with dilution”, which is more a matter of capital structure and outstanding shares. Once the intrinsic value (EV if including debt) is calculated, we use fully diluted shares to get value / share. Note fully diluted in EPS calculations should include nearly all dilution, unvested restricted shares, convertible debt / warrants, and ITM unvested options.
The appeal of this approach is that it feels true to the economic reality of how cash actually moves through the business. It also feels appropriate when considering the value of the company as if it were being bought out today and all SBC was immediately cashed out. The problem is that we are not Berkshire or Google looking at a single moment in time. The dilutions will continue and so share count becomes a constantly moving figure. On top of this, the employees retained would still need to be compensated in cash or by share programs in the acquiring company, and this would not be accounted for. So an M&A type view of the company may not really fit for most investors.
It isn’t a cash expense… but treat it as such!
Another way is to accept the company’s estimate of SBC and pretend that it is a cash expense. Use adjusted earnings or adjusted FCF to come up with your valuation. If SBC is very small relative to earnings, this might not be a big deal. But sometimes this can understate SBC quite a bit and the easiest way to see it is to go through how it is booked.
Suppose Under-Valued Company (UVC) trading at $10 grants a CEO 300,000 restricted shares vested over 3 years on Jan 1st 2012.
• It would debit deferred compensation for -$3M (contra equity negative balance).
• It would credit shareholder equity for +$3M (through common stock at par value and rest in add’l paid in capital or APIC).
Notice that this has zero impact on the balance sheet and each entry offsets the other. This is intended as there is no cash based economic effect on the company. The idea is that the balance sheet shows shares are issued but this doesn’t actually benefit the shareholder or raise cash. Eventually over 3 years the deferred compensation is unwound as shares are vested.
• 12/31/2012 – debit compensation expense -$1M and credit deferred compensation +$1M
• 12/31/2013, 12/31/2014 – same as above
Notice the assumption that the value of compensation is the same for the entirety of the three years. What if the stock was very undervalued, and is trading in 2014 around $30 instead? Some blue chips tripled in value from 2020 lows in a little over 1 year. Here the CEO is considered fortunate from an accounting perspective; their good luck is theirs alone and not the company. However, if the company attempts to balance dilution with repurchases, which arguably a responsible company should do, is the real cost of compensation $1M or $3M in 2014 for UVC? One could easily see how distortions could be worse if the vesting period is longer or for options, if they are sufficiently OTM and carry long expirations (sometimes 10 years). Using Black-Scholes or a lattice binomial model, options could greatly understate their eventual value. Consider 100,000 5-year options with 45% IV, interest rates at 3% at a strike of $20 and the same 3-year vesting period priced at $2.25. It would be accounted in a similar way but no deferred compensation.
• 12/31/2012 – debit compensation expense ($2.25 x 100,000 / 3) = -75k and credit shareholder equity through add’l paid in capital (APIC) +75k
• 12/31/2013, 12/31/2014 – same as above
Again there is no impact on the balance sheet. Because the options expiry date is much farther than the vesting date, the CEO could exercise 5 years later after the stock is at $60. What would happen then? The true cost to offset dilution then would be $6M! In reality, some of this would be offset by the strike price and cash received.
• 12/31/2016 – debit cash +$2M (100,000 x $20), credit shareholder equity +$2M (through treasury stock and APIC).
However, that still means the company will need to layout $4M to buyback shares. This is far more than the $225k recorded in expense. Many will point out these are extreme examples and unlikely but for growth stocks they may not be, and sometimes even great blue chips experience such periods of growth. At the very least, it illustrates we need to think perhaps a little more carefully in the cases where SBC is a higher percent of earnings. So what is a more conservative reality check? I am not aware of any simple way of ascertaining the true cost that doesn’t involve significant forecasting and error but I believe one way to test SBC is with actual buybacks vs. shares issued. u/hardervalue had a great comment on this in another thread:
There is an accounting entry called Stock Based Compensation that attempts to estimate the cost of granted stock options (and any other employee stock grants such as RSUs, warrants, etc).
It's added back to Free Cash Flow since its a non-cash expense, but this is wrong since its treating the company as if selling stock is part of their business. Whenever you estimate true Free Cash Flow you should deduct SBC, because if you owned 100% of the business you'd have to substitute cash payments for the stock.
One problem with SBC is that it uses Black Scholes to estimate the cost of stock options, but its based on beta not intrinsic value. It can be widely different than reality. From 2019-2021 Google only expensed $49B in SBC, but spent $100B buying back stock. They did reduce share count slightly over that period but $51B is roughly double the average stock price during that period so it appears SBC was underestimated by roughly $25B.
I believe therefore we should always look at the average cost of shares purchased during the period (cash laid out to buyback) and multiply this by the actual number of shares issued due to equity-based compensation. Here, Google spent $99.8B buying back shares and repurchased 57.1M shares (average price $1,746). However, the actual share count only decreased by 33.4M. Thus 23.7M shares were bought to offset dilution. So that would seem to imply $41.4B was spent to offset dilution. Additionally $20.6B was spent on net payments related to stock-based award activities. If we add all this together, Google spent $62B cash outlay on stock-based compensation or dilution offsets. SBC was actually expensed at $39.1B in the period (the calculation above may have been generous for Google!) but u/hardervalue's quick back of the envelope calculation overall seems close, it is off by $23B or so.
In any case, I prefer this method to simply accepting what the company tells us SBC is. In addition to looking at average repurchase price, we should also consider:
Changes in SBC over time in terms of shares granted each year and vested / unvested or outstanding rather than only dollar amounts which are influenced more by the share price at granting not the ultimate price when vested or exercised.
Consider that the more undervalued a company is, the greater the potential distortion. Will a big spike in price lead to far higher cost to contain dilution?
Looking at buybacks with greater scrutiny. How many companies lay out the same amounts of enormous cash when stocks crater? In theory they should buyback more not less. They should demonstrate restraint when the stock is high.
In summary, I think it's important to reality test company estimates of SBC, especially since the goal of investing is to buy stocks at what are presumably depressed prices. SBC will be based upon fair value at granting, not when issued, vested, or exercised. In particular we must pay close attention to the average price paid to repurchase applied to the difference between shares bought and actual retiring of stock achieved, since that difference is the cost of containing dilution. At the end of the day though, I have yet to really see any approach that is fool-proof and therefore there is merit to looking at the issue from different angles, applying additional conservatism in the face of uncertainty. I have seen some also estimate SBC by using percent of earnings or cash flow and using that to sensitivity test or plug in various scenarios. I believe this has merit too. My hope with this post is that it might generate some discussion and provoke further thought as buybacks have dramatically increased over the years and it may be obscuring SBC.