Stock-based compensation and free cash flow
In Joshua Rosenbaum's Investment Banking, free cash flow is calculated as: EBIT(1-t) + D&A - Capex - Increase/(Decrease) in NWC. Most sources present the formula for free cash flow this way, without any mention of stock based compensation. However, in the Breaking into Wall Street modules, stock-based compensation increases free cash flow. So FCF = EBIT(1-t) + D&A - Capex - Increase/(Decrease) in NWC + stock-based compensation. Which formula is correct?
I think it makes sense that stock-based compensation should be added back to get free cash flow, since it is a non-cash expense.
Yes I think it should be added back as long as 1) its consistent and 2) It's been included in the calculation of EBIT which it should be
Someone correct me if I'm wrong
it is correct to add back as long as it was an expense above the EBIT line (which is should be)
Not sure if you watched the actual BIWS video, but Brian said the inclusion of stock-based comp depends on the analyst. In other words, each firm has its own way of calculating FCF so there really is no one single "correct" way. The guy above^^ is right: if you're going to include it, make sure you're consistent and include it for all of your comps.
For the IB guys out there on this thread, help me understand something a bit. While I understand the point of the addition for a cash flow calculation, if you're actually trying to value the business then why don't IB guys include sotck based compensation as a real expense? Not only does consistent SBC dilute shareholders absent stock buybacks, but it's still a compensation expense nonetheless...just recognized differently over time. To me this would be like ignoring from COGS if a company used its stock as payment to suppliers.
I think it depends. For MM deals, owner's salaries are typically normalized, so normalization of SBC is relevant. Maybe only the excessive portion should be added back, but this is why modeling and valuation is not an exact science. In certain deals, it should/could be added back and other's not.
The answer is that you need to account for it one way or another. In a valuation model, if you ignore stock based comp in free cash flow, you need to build a share register and show the dilution of stock based comp vesting over time. So if you are valuing the common stock at day 1, what you are really valuing is the value of existing shares. These shares may get 100% of FCFE in year 1, but 99% in year 2, 98% in year 3, etc (to keep it simple). It's the same principle with management incentive in PE deals. The tricky thing to watch out for is if you are valuing unlevered FCF at the WACC, then the present value of future stock based comp would be an adjustment to enterprise value much like net debt in order to arrive at value of existing common equity. If stock based comp is included in your FCF however, then making this adjustment would result in double counting.
As long as you are consistent, as others have mentioned above there is no necessarily 'correct' way of doing this. Different folks will prefer to see it done in different ways. At the end of the day, this is one of the last things you typically focus on and in most cases will not have that much of an impact in your valuation. The uncertainty / margin of error in other assumptions in a valuation model should eclipse the impact of stock based comp, so I typically just include it in G&A as if it were a cash expense to keep things simple (unless I am building a detailed corporate model).
My understanding of stock based comp is that yes technically is it is a noncash expense. However, if you really want to be anal valuing the company. You need to view stock based compensation as a dual transaction where a company independently issues stock options and then uses cash proceeds from those stock options to pay employees. If you view stock based compensation that way, then you would not add back the stock based comp expense. This is much like how one would view issuing debt to buy a machine. Is there a subtraction from unlevered free cash flow from the capex in this case? Yes, but it is then cancelled out with an add back in your levered free cash flow. I view SBC the same way. Of course, this also requires you to find the cost of warrants, which is...a very annoying process in itself.
This can't be right. Issuing options as compensation doesn't result in receiving cash, then using it to purchase shares. That happens when 'in-the-money' options are exercised.
At my bank, we dont add back SBC. When calculating EBITDA, we always calculate EBITDA AFTER SBC. The way it has been explained to me is that, as you said, stock-based comp is just another way of paying someone a salary, and so it is effectively remunerating someone / paying them, out of the business' pocket. I find that interpretation makes sense, but there are arguments on both sides. Definitely depends on the bank/group/person.
^Same, SBC should not be added back
Are there any other line items that are "controversial" like this?
I've been wondering about changes in non-current assets and liabilities. Seems like some models factor stuff in like changes in non-current, non-debt liabilities when calculating FCFs in a DCF. Is that correct? Technically those would still affect changes in cash without being recognized elsewhere in the FCF equation, right?
Depending on the type of share based compensation (Equity based stock options or share based compensation paid out in cash on the basis of the company's share price) the means by which the stock option expense is recognized will vary.
For equity based stock options, the expense itself under IFRS 2 (Not sure the typical treatment under US GAAP - but I imagine its not much different given the FASB - IASB integration) is amortized over the vesting period of the options ( IE. if they are exercisable after 4 years of service - amortized over 4 years). The amount to be vested is usually based on the FV of the options using the black scholes model @ GRANT date. Whereas cash settled share based payments are revalued year after year - these types of options are less common.
You could make a case for either adding back or leaving the share based compensation, depending on the company's situation. For example, since equity based share based compensation is expensed over a period of time on the basis of the FV of the options at Grant using the black scholes, the expense is really a construct on the basis of the model. If say the Company's shares have since tanked and are unlikely to ever be in the money, the Company still amortizes share based compensation expense on the basis of the FV at the grant date when the options might have been much more favourable. In this situation adding back the sahre based compensation is probably more logical since the options are unlikely to have an actual cash impact of any magnitude and really the expense is an accounting construct determined on the basis of the FV of the options at grant.
Thanks to all the responders.
I've been asked about this in a recent banking interview. My view is technically it should be added back since it's a non-cash expense and not doing so would be misrepresenting the actual cash flow of the business (also look at any Cash Flow Statement and you will see this is being added back).
Let's break this down in two different contexts: a) Levered FCF for LBO debt paydown and b) Unlevered FCF in a DCF. On the levered FCF case, I believe it's no question that you would want to add the stock-based comp because you're after the actual cash flow generated by the business to squeeze in as much cash as you can to paydown debt and thus increase a sponsor's return upon exit.
On the unlevered FCF case, I still believe that you would want to add back the stock-based comp because not doing so would be double-penalizing the value of the business. Think about it. In a DCF, value is primarily determined by the Unlevered FCF, Terminal Value and WACC. If the Unlevered FCF deducts the stock-based comp, enterprise value is lower. However, WACC should be reflective of the target capital structure of the business, which is just a weighting of the Debt and Market Cap of the business. I think everyone agrees that Market Cap should be based on the dilutive # of shares (which includes the shares from the stock-based comp) multiplied by the share price. So to the extent that your Market Cap reflects the stock-based comp shares, you're a bit over weighted on Equity, which jacks up your WACC discount rate and also decreases the value of the business. This results in the enterprise value being double penalized. I think you have to make a choice between deducting stock-based comp in your FCF or using a basic share count (i.e. without the stock-based comp dilution) in your WACC calculation. I prefer to just factor in the stock-based comp in my WACC calculation and add back the expense in my calculation of Unlevered FCF to be consistent with the Cash Flow Statement, Levered FCF and WACC calculations.
Hope this helps.
Thoughtful response here and an SB given, though I do disagree with the conclusion in some respects.
2, From a core valuation standpoint, in terms of figuring out equity value and EV and that jazz, I actually disagree that the SBC add-back is somehow double counting. Think of it this way--if a company just gave a CEO a share (not an option) for free tomorrow as a reward for his performance, the journal entries would be Cr $XX APIC, Dr $XX Comp expense, where XX is the stock price. There's both a real expense and real dilution going on here; the CEO gets real economic compensation from the company and the share count has gone up.
I disagree with the notion that the cost of the compensation is fully captured in the dilution part of that equation. If one were to take that view, then granting stock options would be just like issuing stock in terms of increasing equity value, as another poster mentioned. But of course, in the former case, there's no pretty pile of cash proceeds post-dilutive activity, and measuring that foregone cash (and thus foregone equity / enterprise value) through including SBC gets at a core valuation method that accounts for SBC vs. vanilla equity issuances most soundly. Analogous logic applies to the granting of options vs. shares.
Of course none of this matters, as valuation is always a negotiation. There are so many problems with WACC anything more than a sanity check / hurdle rate I often want to punch people.
this is also pretty industry dependent. i can speak from a technology perspective, where the norm is to exclude stock based comp in all non-gaap profitability calcs. in a levered cash flow model (debt paydown), stock based compensation is excluded (added back). in a DCF, the fairness opinion practice among all bulge brackets i've interacted with is to burden the cash flows with the cost of the stock based compensation (do not add it back). simply, stock based compensation is value flowing out of the company, whether now or in 3 years when the RSUs vest / options become outstanding and it has to be accounted for. rather than doing the actual SBC waterfall, which would require too many assumptions, the general practice is to just subtract the amount from unlevered FCF.
This is correct. When calculating cash available for debt repayment, stock comp is added back as its actually lower cash outflows but for valuation purposes it is not included as it is an actual SG&A expense. You're trying to look at companies without giving them benefits for their cap structure vs their comps so you also don't want to reward a company just for using stock comp vs not using it.
^really concisely and correctly said here, my point but in much, much better words. SB given
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