HELP on Modeling the stock based compensation

Unfortunately I have different answers on this topic. When you add stock based compensation back to the operating activities part of the cash flow statement(increases cash), do you actually add this amount to the stockholder's equity directly(increases SE), or do you add this amount to the "change in Working Capital"(decreases cash), which is also in the operating activities section, in order to balance out the balance sheet.
Scenario 1:

Add: Stock-based compensation of $10
-> Cash increased by $10.
Add $10 to share holder's equity.

or Scenario 2:

Add: stock based compensation of $10
-> cash increases by $10.
Add $10 to change in work capital
-> cash decreases by $10.

 

You add the stock-based comp back on the cash flow statement under the other non-cash adjustments like D&A and one-time non-cash charges like writedowns etc.

You add it directly to shareholders' equity in the model. To make the balance sheet balance, cash will have to go up; this makes sense because, like D&A, stock-based comp creates a tax shield so you save on cash taxes.

So in a simple model, the formula would be would be Shareholders' Equity = Previous SE + Net Income + SBC.

Doesn't really make any sense to add it back twice on the cash flow statement, you'd be double counting then.

 

I'm not too familiar with modeling out stock-based compensation (at my fund we always structure this upfront), but at first glance the idea that a change in SE would be fully offset by a change in cash seems wrong.

Presumably, there is another account that would be affected by the compensation adjustment, since cash should only increase by the amount of tax savings associated with said compensation adjustment, while SE should increase by the full amount.

 

Never mind. Thought about it for another second and realized it should balance out when taking into account the impact of reduced net income.

Based on the OP's example, the following should occur:

Cash increases by $4 -> tax shield provided by stock-based comp SE increases by $4 -> increased by $10 from non-cash add-back but reduced by $6 from lower net income

 
Best Response

Stock based comp is a non-cash expense and is thus added back when conducting a FCF analysis. Mgmt won't typically get SBC for an LBO unless they hit specific targets (e.g., EBITDA), which then flows through to your waterfall analysis for payout.

As for equity analysts for a public company, SBC may be backed out of a model for non-GAAP ("cash") earnings. Some management teams will try to buy back stock each quarter to offset any dilution from issuing SBC, but that's not always the case. In any event, it's a non-cash expense that can be backed out.

 

So let me get this straight guys (or gals).. as Wall Street valuation experts, you'd assign a higher value to a company that was issuing out more stock than cash to its employees due it its higher FCF? I.e. if everyone in a theoretical company for example, got paid like Steve Jobs, $1 in cash, but got gobs of stock and options, that company would have a higher value, all things being the same, vs. a company in which the employees and management got only cash comp worth the same? I agree with you Devils Advocate in your scenario of going private and illiquid, but why should it be special, and not the general case, when it comes to determining valuation?

 
smfusr:
So let me get this straight guys (or gals).. as Wall Street valuation experts, you'd assign a higher value to a company that was issuing out more stock than cash to its employees due it its higher FCF? I.e. if everyone in a theoretical company for example, got paid like Steve Jobs, $1 in cash, but got gobs of stock and options, that company would have a higher value, all things being the same, vs. a company in which the employees and management got only cash comp worth the same? I agree with you Devils Advocate in your scenario of going private and illiquid, but why should it be special, and not the general case, when it comes to determining valuation?
if a company were issuing tons of stock based compensation, its cash position wouldn't be affected but you would be diluting the returns of existing shareholder.

think of it this way: you wouldn't "assign a higher value to a company issuing out more stock than cash"... u would assign a higher value to a company that was generating a higher PV of future cash flows. if u are issuing more and more shares, nothing is happening to the cash.... the overall value of the firm doesn't change, but the value of each share will go down b/c of the dilution. net net total firm value is unchanged.

if i am wrong, somebody plz correct me. not an expert by any means but this is how i perceive it.

 

When constructing a CF, we adjust for non-cash charges to take into account the temporal issues with the charges. The IS calculates the the quarterly “charge” which is financed either through an accrual or cash. When we calculate the Cash Flow - adjustments are made for the accruals ..i.e. working capital .. in the long run, all accruals will net out with cash expenditures... e.g. the depreciation cannot exceed the capital that’s being depreciated... the comp being amortized cannot exceed the total comp.... when you add back only stock comp amortization without offsetting the initial outlay, you’re basically doing the equivalent of adding back depreciation without offsetting the capex. You are inflating the Free Cash Flow.

What you are really doing when you add back stock comp is taking cash flow from Financing (in this case, rasing of additional equity, and transferring that to OCF). Issuing new stock IS cash. Think of two exactly equivalent scenarios: in one, the company issue $10m of stock at $5/shr when the stock price is $8. The company collects $10m, records a (2m shrs x $3) = $6m charge, and pays the CEO $10m. IN which case, the company will record 10m in salary costs and include them in the OCF. Now the company doesn’t want to do that, but instead issues $10m worth of options to the CEO, which the CEO exercises immediately. In that case, the company knows analysts will include any additional charges in the IS or OCF, just report a slight increase in share count. The only thing the poor analyst will do is slightly increase the share count. BOTH ARE EXACTLY THE SAME CASES ECONOMICALLY - just executed differently. In reality of course, its more complicated due to vesting and temporal issues.

My point is that the issuance of stock comp should be factored into the OCF and Income statement AND increase dilution, not just increase dilution as many propose.

 

When you add back depreciation expense for PP&E on the SCF, you aren't offsetting the capex, you are simply reversing the depreciation expense that you took during the period from net income because it was not a cash flow. In the case of stock-based comp, no cash changes hands until the grants are exercised, at which time the company gets paid, not the individual. The individuals are then free to dump their shares on the market at the market price, which is much higher than the price they paid. The fact that the company gave away shares at a lower price than the market price dilutes the value of each person's ownership in the company.

The simplest way to think about it is that as share-based comp vests, it is expensed, thus reducing net income. However, the company paid no cash, so they need to add it back to net income to get to actual cash flows. Future cash flows are now worth less to the individual shareholder because each shareholder owns a smaller percentage of the company.

The actual issuance of stock has nothing to do with the expense and is a cash inflow. Also, in the example you provided, the cash inflows from issuance and outflows to the CFO will offset on the SCF.

 

The bottom line is, yes it's a non-cash expense, but it's still a real expense and that's why it would be dangerous to value a company based on FCF estimates that build in high levels of SBC, unless you're accounting for the dilution elsewhere in the valuation.

I think the best way to look at it is to ask yourself, what is the difference between SBC and issuing equity to the public to pay employees in cash? If you do the former you have higher CFO and higher FCF assuming you account for SBC as a non-cash expense to be added back. But I'd say the fundamentals of the situation did not change much at all (depends on how the SBC is structured, it's probably not literally issuing equity right to employees but rather options or stock that vests over time).

Now on the flipside, especially because SBC is often options or otherwise is vesting over time, some would argue that the way it is expensed [i.e. if options, it'll be expensed based on black scholes value] doesn't accurately reflect the economics of the situation. Basically, it's of course more difficult to value options you issue to employees than it is to value cash you pay to employees. So if you believe the number expensed for SBC doesn't reflect the real economic cost, then you might want to make adjustments.

I think the safest (conservative) thing to do is to not add back SBC and treat it as a real cash expense. But it's really a complicated situation and kind of a judgment call you have to make.

 

Think about it from a transaction perspective. Let's assume you have a company with SBC for management and that the company is being targeted for takeover and will become a private company post-close. If SBC is a significant part of management's comp, then you'd have to replace that with cash comp if SBC is no longer an option.

Actually, I guess that last sentence isn't strictly true in all cases, but it's the other way to think about it.

 

Thanks for the help! 1) Got it- since SBC is not showing up in the historical Income Statement though (in the 10-k), does that mean I need to back out the historical SBC from COGS/SG&A and separate it out? How would I do that? 2) How would I back out the D&A from COGS / SG&A? And out of curiosity why is some of it baked into COGS / SG&A?

 

Additionally, what do you if Working Capital differences on balance sheet compared to the CF statement are different?

For instance:

Inventory in FY 2013 is $1,090.9 Inventory in FY 2012 is $1,111.2

$1090.9-$1,111.2= -$130.3, thus should add back $130.3 to CF.

However on the CF statement the inventory adjustment in FY 2013 is $152.5

This happens with other WC accounts too.

 

The inconsistencies on the CF statement and IS or BS aren't only for Inventory. I see differences in Net Income, Depreciation expense, etc.. Not a CPA. Does anyone know why?

 

I've worked in both IB and PE, and at both jobs we would typically add back stock based comp to get free cash flow. In my PE job we make sure to include those shares as a form of ownership dilution in our model, so the economic cost of that compensation still gets worked in. This step always seemed to be missing in banking - we would add back the stock-based comp expense but then use only the current options and warrants.

 

Downtown - I get what you're saying.. but if you only take into account dilution as the result of SBC, you're not really taking into account the economic impact. SBC has an economic worth. Assume (x/y) is the current price / shr of the company (i.e. x= value , y= shrs out)... if you had an incremental stock comp of (a for new shares b) according to you the new price would be (x+a)/(y+b).... in that scenario as long as the stock comp was issued at the current price, there'd be no change in the value. This would be true if the stock were issued by the company and an asset of the company. BUT that is NOT waht's happening. New stock is being issued, but the cash being raised is being immediately expensed as compensation, except that the "raising cash" part is being skipped by directly giving the stock to the CEO or employee. In this case, its a direct transfer of wealth from the new shareholders to the management. It is an EXPENSE and results in a reduction to the value of the company. Think of it this way - if a company were to raise cash and give it as salary - you'd take it out of OCF AND dilute the stock. If the stock is given directly to the mgmt, why ONLY consider the dilution? By your math, the if all employees were paid in stock, the company would have a higher value.

 

I am taking into account the economic impact. If there is no cash outflow corresponding to the stock comp then the total equity value in a DCF does not change. However, there are potentially more shares to claim that equity value, so my value per share as an existing invesor falls. Same with IRRs: the total equity value at exit doesn't change since cashflow isn't impacted, but my ownership share of that value gets diluted, so my IRR falls.

For your example of selling new shares to cover salary costs...the company would owe that money to employees whether they do an equity offering or not, so your total firm value isn't changing before the capital raise vs. after. It just gets diluted based on the new capital that has to finance that cost.

 

Downtown,

How would you value a company which had revenue of $10m in perpetuity, expense of 4m paid out in stock only, not cash, also in perpetuity? No other expenses assets or working capital. Lets say cost of equity 10%. What would be the FCF you would use?

How would your answer change if the comp was in cash?

 

If expenses are paid in stock, annual FCF = $10m, so total equity value = $100m. However each year into perpetuity I have to give up $4m worth of equity value to pay for expenses, so I'm conceding $40m of value today. Therefore my NPV as the original investor = $60m.

If expenses are paid in cash, annual FCF = $10m - $4m = $6m. NPV to me today is $60m.

 

Agreed! whether comp is in stock or not, shouldn't matter!!! .. do what you will, dilute this adjust that.. fact is economic value is being taken from the shareholders and given to the employees as compensation for services rendered.. the company may as well issue stock and go buy diamonds or gold and pay its employees.. you can still call that "non-cash" and exclude it from your calcs and inflate the FCF... you'll end up doing 2 things.. you'll dilute the shareholders AND you'll give mgmt a paycheck ... that paycheck doesn't come out of nowhere.. it comes out the shareholders asses!....

btw - same way we include T-bills as "cash and cash equivalent", we should include stock comp as "cash equivalent".. hell if I'm working and getting paid in stock, I really don't care.. pay me in whatever assets.. gold, platinum, rhodium.... i just care about the economic worth of what's being given to me (adj for liquidity and txn costs of course).. that's coming out of the company from somewhere.. from the existing shareholders.. only thing is if the company FIRST raises cash by selling stock and gives it to me, its and expense, if it gives me stock directly, magically, its "non cash" and added back to FCF and some ridiculous accounting based dilution adjustment is made by the likes of Wall St elites thinking they've fully factored in what's happening.. all to overvalue the company in the end

 

I can't really tell what you're getting at - you seem to change viewpoints within your post.

So I'll just reiterate what I said originally and hopefully that helps answer your original question: in my IBD gig we would add the future stock based comp back, but not tack on additional options, RSU's etc. onto the current fully-diluted share count, so our valuations were somewhat inflated. In PE we plan on setting aside a certain % ownership of the company to cover management equity incentives, so we account for that compensation cost as a form of dilution we experience between entry and exit.

 

Not to belabor my point but I'd say that the equity offered to/set apart for management in an buyout is not technically stock comp, as its is an principal ownership stake right from the beginning, not compensation as "salary". I think warren buffet said it best.. with regards to SBC.. if SBC is not compensation, what is it? if compensation is not an expense, what is it? and I add... if an expense shouldn't be included in FCF, where should it be?

Lets not forget the definition of FCF is cash flow that accrues to existing stock holders at the time of calculation... you cannot model FCF properly if you have new equity being constantly raised... if you do that, you have to dilute the share count by the shares that represent the present value of future SBC, NOT the accounting definition of dilution... remember how you arrived at 100m for the value of the company w/ salaries being paid in stock in our example? you have to dilute that by the new shares that represent the 4m in expense in perpetuity. .i.e. 40m.. way more than any accounting dilution done using the treasury method.

*** Lets not forget that the value of the company should be same as if stock comp was expensed and treated as cash***

 

Assume that the company in your description pays out US$4m in cash, and the employee immediately buys some new stock options from the company. The company now still has US$10mn in FCF, and the employee has stock options which has dilution effects (it's like they now hold the employee stock options). Then you use that US$10mn to arrive at the NPV while acknowledging that x years later you will have to pay cash(or not gain cash), so to speak, when the option is exercised. So the FCF is actually 10, 10 ,10, ..., 10, 6, 6, ... Assume, instead, that the employee doesn't buy new stock options from the company. The company now has only US$6m in FCF, and thus will have a lower NPV. And thus you should add back ESO and also count in the dilution effects like Downtown said.

That's how I understand it. Please correct me if I am wrong.

 

Expenses over the period between grant date and vesting date.

Ex. Grated 100 stock options. Option fair value at grant date in total = 10,000. Vested in two years.

At end of year 1, expense 50,000. At end of year 2, expense 50,000. Kind of combining the principles of revenue/expense matching and obligation. No obligation exists at grant date (only arises when vested), but weird not to match the services of employees to the time of their service, so hence expensed over the period.

 

It depends if it's equity settled or cash settled. If the former, then it's expensed as vested. Equity settled options have a vesting period, typically 5 years though it depends. Cash settled SBC is determined at fair value annually with changes reflected as an expense. For more clarity, refer to ASC 718/IFRS 2.

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