INTRODUCTION
Stock based compensation (SBC) presents a problem for investment analysts in a number of ways:
1 almost every company adds back SBC in its calculation of adjusted earnings. These are overstated to the extent that payroll costs would have had to be (much?) higher without this issue of stock to employees.
2 because SBC expense is a non-cash item, it is added back in the calculation of operating cash flows. Cash flow multiples are therefore understated. Although buybacks are often deployed to offset the dilution from the issue of shares to employees, this cost is not reflected in Free Cash Flow multiples.
3 Valuations should at least factor in the impact of the options outstanding on market cap, but analysts often forget this adjustment. Some analysts include this in the number of shares used to calculate eps, but there is no consistency.
HOW TO RESOLVE THIS?
When I was an analyst at hedge funds, this issue of SBC was generally not as significant as now. My standard approach then was to inflate the share count to reflect past and forecast option issuance; in rare cases, I might adjust the cash flow for implied buybacks. Using the inflated EV to reflect the shareholder dilution was generally sufficient for my valuation purposes.
But the scale of the problem has increased, partly because many tech stocks in particular have been very successful and as the share prices have risen, so the value of the options has increased significantly. In practice, this means the cost to shareholders of the dilution is higher, so it’s something we should be concerned about. The chart from a smart analyst in a family office who follows the SaaS sector shows that its SBC to revenue has more than doubled.
Source: @crowdedtradecapital
OPPORTUNITY COST
The accounting standards in respect of stock based comp leave a lot to be desired. This is normal. I don’t like most of the new standards. Their idea here I think is to give a measure of the opportunity cost at the time of grant – hence if there is a cost in year 1 of an option vesting over 3 years, the IFRS says that the cost is spread over the three years. This is not varied if the share price quadruples in year 2, which is obviously a problem, as the cost to shareholders has increased significantly. Similarly, if the share price goes up, the real cost of the pool increases, but this is not reflected in the P&L.
This would be less of a problem if there was adequate disclosure and analysts could calculate the effective opportunity cost each year, which is what shareholders should be concerned about. Unfortunately, insufficient data is given for this analysis to be performed. I am not one to suggest that accounts should be made any longer or more complicated, but this is one omission which is hard to understand, easy to rectify and where the investment community would see a real benefit.
ONE SUGGESTED SOLUTION
Given that it’s a much more important issue today, I decided to revisit the subject of stock based compensation with some practical suggestions for analysts and investors. These are simply some top of the head thoughts and I would be interested in feedback.
Before looking at possible solutions, let’s assess the problem by looking at some examples. For Twitter, SBC is the principal adjustment to EBITDA as can be seen from the table – this is similarly true of Facebook, less so for IHS Markit and Netflix.
STOCK BASED COMPENSATION TRENDS ($M)
TWTR INFO FB NFLX
2014 632 159 1,837 115
2015 682 129 2,969 125
2016 615 183 3,218 174
2017 434 262 3,723 182
2018 326 242 4,152 321
2019 378 224 4,836 405
% Revenue 20.3% 6.4% 9.2% 1.9%
% Rep EBITDA 170.7% 22.3% 18.0% 3.2%
%Adj EBITDA 62.8% 16.8% 15.7% 16.8%
% EBITDA adjustment 99.3% 67.2% 120.0% -4.0%
Source: Sentieo data and BTBS calculations
LET’S SET OUT THE PROBLEM
At the start of 2014, lets say you were a successful venture capitalist and you owned 5% of Twitter and 5% of Facebook (ok, very successful VC). You would have owned the following:
Twitter Facebook
at start 2014
Share price 67.5 54.71
Nr shares 28.5 127.4
Value ($bn) 1.9 7.0
You would have done much better with your Facebook stock, as we know, which would have nearly quintupled as opposed to Twitter which actually declined! But let’s look at what happened in the 6 years 2014-2019 in terms of stock based compensation (all data from Sentieo):
Twitter’s charges for SBC in those 6 years amounted to $3.1bn, for Facebook the total was $20.7bn. Large numbers and equivalent to 8% of the opening market capitalization of Twitter and 15% for Facebook. Had you known this fact at the start of 2014, that might have coloured your view of the shares, but let’s consider the relative significance of SBC for the two companies.
The conventional way of assessing this might be to compare these charges to the respective P&L statements and that’s quite easy to do, as illustrated in the above table. But the real challenge is to assess the economic impact of the issue of this stock to employees, which is more complex.
The table above shows the SBC expense from the accounts which for Twitter over the 6 years amounted to 20% of revenues and 1.7x reported EBITDA and 63% of adjusted EBITDA. For Facebook, the same ratios are 9% of revenues, 18% of reported EBITDA and 16% of adjusted EBITDA.
But this is not much help from an economic perspective – we really want to know how many options were issued, how much cash was received (not much usually) and what the company would have needed to spend on buybacks in order to offset the dilution.
In the case of Twitter, Sentieo’s standardized cash flow helpfully gives you the cash received from the exercise of options – just $67m. By analysing the Consolidated Statements of Stockholders Equity, we can assess the number of shares issued each year on the exercise of stock options and in relation to the vesting of Restricted Stock Units.
There is a difference here in that I am calculating the stock actually issued rather than the options granted, which forms the input to the SBC expense line. But in practice the real economic cost to the business is the stock actually issued – this is what actually dilutes shareholders, not the options issued.
Over the six years, 193m shares were issued by Twitter to its employees and with a share price which fluctuated between $16 and $36, we estimate the value of the stock issued was $5.4bn or $5.3bn after taking cash receipts into account (we have not checked the receipts number which looks low, but it’s not important for this analysis).
SBC expense in Twitter’s P&L totalled $3.1bn, vs the actual economic cost of $5.3bn net – a massive difference. This suggests that using the actual stock issued in the year at the average share price looks likely to be a better indicator of the true cost to shareholders.
Doing the same comparison for Facebook, we get 269m shares issued in the period and a total value (at average prices in each year) of $35bn which compares with $21bn of SBC in the same period. For Twitter, our estimate is 75% higher than the total reported in the accounts and for Facebook our estimate is 70% higher – these are significant differences, for two tech stocks pulled at random.
US companies are incentivised by the tax legislation to use share options because the options are a deductible for tax purposes. For some companies, the use of stock options is likely more significant than the examples portrayed here. But in all cases, the current practice of effectively ignoring the cost, and taking the benefit of the expense in a reduced tax rate, is sloppy analysis, in our view. This is a double whammy benefit to the companies’ apparent valuations.
I intend to apply this methodology in future work in this area of institutional clients and shall study the results closely. Alternatives to the current system should surely be explored – your views would be welcome.
CONCLUSIONS
Stock-based compensation is a growing problem for equity analysts and investors.
1 New forms of doing business and the growth of intangible assets present problems for users of accounts. The increasing use of stock-based compensation is just one aspect.
2 The use of option valuation models is a theoretically attractive solution of how to account for stock-based compensation. But it presents its own difficulties; we would argue that it understates the real cost and is not strictly representative of the economic cost relating to that year’s options.
3 Almost every company adds back SBC into its calculation of adjusted earnings and adjusted EBITDA – if investors agreed that this was sharp practice, companies might desist from this misleading presentation. A better and standardized process for calculating the economic effect of SBC would be a great start to improving the realism of “adjusted” earnings.
4 Adjustments are required in the calculation of market cap, enterprise value, earnings, EBITDA and operating and free cash flow. We have set out some suggestions in this blog as to possible calculations, but there will be other solutions.
Accounting standard setters often seem to search for theoretical answers which will be elegant, but these can sometimes be difficult to calculate with substantial subjective assumptions. We would prefer simple solutions which are roughly accurate most of the time. This has been true since 1994 and the introduction of the Cash Flow Statement with FRS1 – it had to be significantly revised. But the accountants have not learned their lesson, witness IFRS 16 which is an economic nonsense. Increasingly, analysts will have to adapt accounting data to provide more realistic economic assessments. Stock based compensation is just one area, but one where it would be relatively easy to improve current reporting.