Stock Based Compensation and FCF modeling
Hi there,
In my DCF model, I am considering subtracting the stock-based compensation from my unlevered free cash flows. Although some argue that stock-based compensation is a non-cash expense and should be added back to unlevered cash flows, if the options were issued to the market, the cash proceeds would be used to compensate employees, so it could be considered as a cash outflow and subtracted from the unlevered cash flows.
What do you think - substract or add? Help is much appreciated
no no and no do not subtract it noob
definitely don't subtract: add if it's recurring but i'm guessing it's not
generally fcf to firm = ebit*(1-t)+D&A-capex-increase(decrease) in nwc
can also use ocf - capex, but make sure to adjust for things in ocf that aren't recurring
some1 plz correct me if i'm wrong
SBC is definitely recurring - in short, you shouldn't subtract it (make sure your EBIT doesn't include SBC either).
Maybe later today I'll edit this post and explain further some reasons people could give to both add it back to GAAP Net Income or to keep it out.
EBITDA add back (noncash). You are trying to get to get to an actual unlevered free CASH flow number which can distributed to satisfy all investor claims in a cap structure (e.g. you can div out to equity or paydown debt w/).
Has abs nothing to do w recurring vs. nonrecurring (e.g. GOOG has a ton of Recurring SBC, but obv its a non cash operating item which must be added back to EBITDA). Go back and really try to understand what EBITDA is and how it is calculated. Why it is a proxy for pretax unlevered operating cash flow and what that means. Trust me it will be worth your while.
I can't speak for tech companies where stock comp might be a big add-back, but I know that in industrial companies, SBC is considered a normal expense and is not added back to EBITDA as an adjustment - when we look at comps, we include the SBC expenses.
With that in mind, for your FCF, the proper method would be to include the expense in your EBIT and then add it back as a non-cash expense in your cash flow (in which case, you're getting a tax shield). Or you can just ignore it completely since it's probably not significant. But definitely don't subtract it in your cash flow - it's not a cash expense.
It's not a matter of tech vs. non-tech. It's a non cash expense that has nothing to do with cashflow and EBITDA. The only issue really comes down to reporting - industrial cos don't readily break it out as rigorously as tech companies and sometimes its less influential of an expense, hence the tendency to ignore it (esp on a quarterly basis when disclosure in a Q is minimal). However when you get the K you should def add back to adjusted EBITDA.
FYI OP your original language was something like "some argue" -- this isn't that trivial -- imagine a situation where the IRR calc you present is all of a sudden wrong because you're miscalculating the dividend potential of a company...
what about is the "currency" used is stock? case in point... companies can buy companies using stock entirely... does that mean that we shouldn't include it in capex?
people only usually include pp&e in capex but want if your company grows entirely through acquisitions? e.g. 3d printing
Durban. If you are treating the SBC as a non-cash expense (basically ignoring it), how do you account for the fact that the issuance of these options dilute the current share holders? Isn't the issuance and exercise of stock options effectively a transfer of wealth from existing share holders to those receiving the options? Sure, it may not affect the cash flows in the most literal definition of cash flows, but it certainly affects the stock price? If you are not deducting it as an expense, how do you deal with the dilutive effect of the options?
SMFUS had some very good points below. Dr. Damodaran talks about this at length in his treatises on valuation. For instance, he states in one text:
There are some accounting and valuation analysts who argue that option grants do not affect cash flows and that they therefore do not affect value. This argument makes no sense. After all, if the option-granting firm had issued the options to the market (as traded warrants) and used the resulting cash proceeds to compensate employees, we would have considered it an operating expense. We cannot reward firms for using their equity as currency. If we do, firms may very well switch to paying for everything with equity (stock or options) and claim to have no cash expenses at all. (Damodaran on Valuation, p. 377)
Thoughts?
Thanks a lot for the explanation, guys.
In addition, here is another question I have: I am analysing a media company and when considering the Capex on the cash flow statement, it only includes PP&E. However, the company has substantial "programming costs" as it purchases rights for programming. The programming costs go straight to P&L and are not part of the inventory. I am wondering whether I should in the FCF calculation use only the Capex that is on the CF statement, or include the investment in programming, or a change in programming, as well. Thank you
Some may differ but including other types of fixed assets to broaden the CAPEX definition is fine if those assets are supporting the long term growth of the business. Def footnote that.
footnote shmootnote
Pindur - you are absolutely spot on regarding your instincts. Stock compensation is a very misunderstood topic. I've had CFO's passionately resist any suggestion to subtract stock comp from free cash flow.
However, consider this: Lets say, we have a company that only pays its employee's in stock, and has no cash expenses. So we have a very simple PnL, i.e. Non-GAAP Profit = Revenue. If you were an investor, and thinking of buying this company, what FCF would you use? Rev minus some value of compensation for the employees, or as is suggested by so many, simply Revenue?
What most do not realize is that stock compensation is effectively a net transfer from Cash Flow from Financing to Cash Flow from Operations. When a company issues out stock options and equity, it generates cash flow from financing, and the equity balance increases. When it pays that amount out to employees as compensation it is a value transfer out of the company. Yes, technically its not "cash" per se, but its not exactly worthless.
If you got paid in diamonds or gold by your company, does that mean the company is not incurring any expenses for procuring the diamonds or gold? Similarly, when a company issues stock options, and employees exercise them, the company is effectively issuing stock at well below market prices. Suppose an employee is about to exercise options issued options for $2 strike, when the stock is at $8. In effect, if he exercises the options, it is exactly the same economically as the company issuing the stock at $8, and holding on to $2, and paying out $6 to the employee. In that case, you'd have a $6 expense reported in EBIT and cash flow, whereas, if you ignore and add back stock comp, you'll ignore it completely.
In that case, every company can significantly increase FCF simply by issuing more stock and paying its employees that way instead of cash. Does that make the company more valuable? I don't think so.
The issue is what value should you assign to the stock compensation to use in the cash flow statement? I'd say, the accountants have already done the work for you. The easiest, simplest and cleanest method would be to use the GAAP stock comp charge as reported. That's also the figure that is required to make the statement of stock holders equity balance.
Your boss(es) may not agree with this approach obviously since many companies will look vastly overvalued. But that's a political issue.
Good luck!
@Sasan88 - Stock acquisitions are a bit of a different beast than SBC because you get something for your stock - granted there's probably a big slug of goodwill (i.e. potential value destruction), but otherwise you can identify assets and other income-generating intangibles.
However, as it relates to companies that grow by M&A, that leads to the other question of whether you should add back amortization of acquired intangible assets to non-GAAP earnings; there, IMHO, depends on the company - if the acquisitions are non-recurring and there was a large slug of amortization then add it back, but if you're buying technology (effectively capitalizing R&D) or customers (capitalized SG&A), you should expense it.
for DCF, need to calc cash flow, thus make sure any non-cash expenses (including SBC) are not treated as cash expenses
to reflect the economic value of SBC, include the options in the share count
What about future dilution which is what you are capturing with SBC? Do you have an authoritative source for forecasting future dilution?
My favorite approach is Damodaran's - he simply ignores dilution (as in number of shares) altogether. It may seem outrageous until one sees the reasoning. Most people get confused when trying to properly take dilution into account. He values everything and take it out of the overall equity value, for a more representative result, without the need to mess with the number of shares.
Basically
Option expenses are expensed and you have EBIT (1-t) ready for your FCFF calculation. Forecasts for future option expenses depend on a few factors (check the link I'll post below)
R&D expenses should be capitalized. For EBIT (1-t) calculation that means adding back R&D Expenses while taking out the amortization of the R&D assets. A part of stock expenses may be considered part of R&D, and that part would come here. You can look at the change in ROC for past years to hep in your assessment of the R&D effectiveness of a company.
The most precise way of dealing with the effect of past options that are still "alive" is simply to value them by using a modified Black&Scholes or a binomial model. Alternatives usually ignore the time value and volatility. It's much better to account for them somehow than to simply ignore them. Instead of diluting, just take this option value out of the equity value of the company (you may also calculate a tax shield depending on the jurisdiction) and then you can divide your common equity value by the number of shares, WITHOUT dilution - the effects of dilution were already measured in dollars and in a more precise way.
For a thorough explanation, showing what he believes are the flaws inherent to other approaches and the caveats of his approach, check this out (it covers both R&D and options):
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=841504
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