It is common today for companies to exclude stock-based compensation (SBC) when reporting “adjusted” earnings.
In management’s eyes, SBC expense is not a cash outflow and is excluded when reporting adjusted earnings. But don’t let that fool you. SBC is a real expense for shareholders. It increases a company’s outstanding share count and reduces future dividends per share.
I’ve thought about SBC quite a bit in the last few months. One thing I noticed is that investors often do not properly account for it. There are a couple of different scenarios that I believe should lead to investors using different methods to account for SBC.
Scenario 1: Offsetting dilution with buybacks
The first scenario is when a company is both buying back shares and issuing shares to employees as SBC. The easiest and most appropriate way to account for SBC in this situation is by calculating how much the company spent to buy back the stock that vested in the year.
Take the credit card company Visa (NYSE: V) for example. In its FY2022 (fiscal year ended 30 September 2022), 2.2 million restricted stock units (RSUs) were vested and given to Visa employees. At the same time, Visa bought back 56 million shares at an average price of US$206 per share. In other words, Visa managed to buy back all the shares that were vested, and more.
We can calculate the cash outlay that Visa spent to offset the dilution from the grants of RSUs by multiplying the number of grants by the average price it paid to buy back its shares. In Visa’s case, the true cost of the SBC was around US$453 million (2.2 million RSUs multiplied by average price of US$206).
We can then calculate how much free cash flow (FCF) was left over that could be returned to shareholders by deducting US$453 million from Visa’s FCF. In FY2022, this FCF was US$17.4 billion.
Scenario 2: No buybacks!
On the other hand, when a company is not offsetting dilution with buybacks, it becomes trickier to account for SBC.
Under GAAP accounting, SBC is reported based on the company’s stock price at the time of the grant. But in my view, this is a severely flawed form of accounting. Firstly, unless the company is buying back shares, the stock price does not translate into the true cost of SBC. Second, even if the stock price was a true reflection of intrinsic value, the grants may have been made years ago and the underlying value of each share could have changed significantly since then.
In my view, I think the best way to account for SBC is by calculating how SBC is going to impact future dividend payouts to shareholders. This is the true cost of SBC.
Let’s use Okta Inc (NASDAQ: OKTA) as an example. In Okta’s FY2023 (fiscal year ended 31 January 2023), 2.6 million RSUs were vested and the company had 161 million shares outstanding at the end of the year (after dilution). This means that the RSUs vested led to a 1.7% rate of dilution. Put another way, all future dividends per share for Okta will be reduced by around 1.7%. Although the company is not paying a dividend yet, RSUs vested should lead to a reduction in the intrinsic value per share by 1.7%.
More granularly, I did a simple dividend discount model. I made certain assumptions around free cash flow growth and future dividend payout ratios. Using those assumptions and a 12% discount rate, I found that Okta’s intrinsic value was around US$12.5 billion.
With an outstanding share count of 161 million, Okta’s stock was worth US$77.63 each. Before dilution, Okta had 158.4 million shares and each share was worth US$78.91. The cost of dilution was around US$1.28 per share or US$201 million dollars.
Scenario 3: How about options?
In the two scenarios above, I only accounted for the RSU portion of the SBC. Both Okta and Visa also offer employees another form of SBC: Options.
Options give employees the ability to buy stock in a company in the future at a predetermined price. Unlike RSUs, the company receives cash when an option is exercised.
In this scenario, there is a cash inflow but an increase in share count. The best way to account for this is by calculating the drop in intrinsic value due to the dilution but offsetting it by the amount of cash the company receives.
For instance, Okta employees exercised 1.4 million options in FY2023 at a weighted average share price of US$11.92. Recall that we calculated our intrinsic value of shares after dilution to be US$78.91. Given the same assumptions, the cost of these options was US$66.99 per option, for a total cost of US$93.7 million.
Key takeaways
SBC can be tricky for investors to account for. Different scenarios demand different analysis methods.
When a company is buying back shares, the amount spent on offsetting dilution is the amount that can not be used as dividends. This is the cost to shareholders. On the other hand, when no buybacks are done, a company’s future dividends per share is reduced as the number of shares grows.
Ultimately, the key thing to take note of is how SBC impacts a company’s future dividends per share. By sticking to this simple principle, we can deduce the best way to account for SBC.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Okta and Visa. Holdings are subject to change at any time.