Stock-Based Compensation - Why stock-based compensation also reduces free cash flow
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Looking at companies' quarterly and annual figures, one gets the impression that share-based payments (Stock-Based Compensation) for employees have no impact on free cash flow. Initially, this also appears conclusive, since from a purely technical point of view there is no cash outflow. Employees receive stock options and/or restricted shares instead of salary payments, which do not appear in the cash flow statement in each case. Why, despite this fact, I firmly believe that you should deduct stock-based compensation (SBC) from your FCF calculation is explained in this article.
If you're more audiovisual inclined, feel free to watch my in-depth video on the subject:
Where can I find stock-based compensation in the company's financials?
According to my DCF analysis on Hellofresh I had an interesting comment that I am really anything but making fun of, but can very well understand that there is widespread confusion here. The commenter was of the opinion that SBC are not operating costs and do not appear in the Income Statement or P&L. In addition, that they do not negatively impact FCF. There is truth in the last statement, but I completely disagree with the first part.
Let's take a look at the Tesla example. Don't worry, you don't have to look at the boring slides from the filings. You will be able to follow me and if not, feel free to write your questions in the comments.
Here you can see the Income Statement from the SEC filing for the full year 2021:
Even after a long search, you won't find Stock-Based Compensation here, yet there it is. As is so often the case, elementary components are hidden outside the income statements. Let's get this straight right from the start: This does not apply exclusively to Tesla. I use the company here as an example because the SBC is particularly high here and therefore the effect is particularly pronounced. To find the stock-based compensation, you will unfortunately have to dive back into the company's filings to find what you are looking for.
Here, however, you can now see where the SBCs can be found, namely always under the items in the income statement to which the corresponding employees are assigned. If an employee from the research and development area receives the compensation, the costs are Research and Development (R&D). If, on the other hand, Elon Musk receives a block of shares, it is Selling, general and administrative (SG&A) are allocated. Both are clearly operating costs or operating expensesas you can see from the "Income Statement" above. A point that, by the way, is also Agree with Warren Buffet would. This is also only understandable as it is a component of the salary payments for the relevant employees.
By the way, if you've ever wondered what "GAAP" and "non-GAAP" are all about in SEC filings. Often SBCs are one, if not 'the' important factor, which is excluded from "Non-GAAP" in order to make the figures look a bit 'nicer'. The same often applies to the unattractive word "adjusted" in "Adjusted EBITDA", etc.
Free cash flow in general
The question as to whether SBCs are operating costs can therefore be answered in the affirmative. Let us now consider the case of free cash flow. As a reminder, FCF or what I always refer to as FCFF (Free Cash Flow to Firm) is the part of the cash flow that is available for distribution to all providers of capital of a company after costs, taxes, increase in working capital and investments (less any disposals). This capital could therefore be distributed to the providers of capital without depriving the company of much needed funds. I am not the only one to consider the FCFF as the most important indicator when calculating the value of a share.
Let's look at Tesla's cash flow statement again as an example, but this is also true for any other company reporting under US GAAP accounting standards:
As you can see, the stock-based compensation is added back to net income and thus increases the operating cash flow. This is also correct from a purely formal point of view, since SBCs, although they are also operating costs, do not result in any cash outflows from the company, and this is what the cash flow statement is intended to show.
Often companies as well as analysts then tend to subtract capital expenditures (CapEx) from operating cash flow to arrive at FCF. FCF Tesla calculates in line with this in its Slides for the full year 2021 free cash flow as follows:
We will leave aside the fact that Tesla does not include finance and capital leases in its calculation of capital expenditures, even though this also has a significant impact on the reported FCF. However, this is something that some analysts correct in their FCF calculations because it is almost indisputable from a purely objective point of view. We now come to the disputed part, which is often ignored by analysts.
Does stock-based compensation reduce free cash flow?
The question seems trivial at first, since we have already established that there are are not cash expenses. Nevertheless, I am convinced that we also need to deduct stock-based compensation from free cash flow in order to obtain a meaningful result.
When we value a share, we should be less interested in how much free cash flow the company behind it generates, and more interested in how much of the cash flow is attributable to our share or stake. I think it makes a difference to you whether 10 million euros FCF is distributed over 10 or 12 million shares of the same company. You would hardly think of assigning the same value to the share in both scenarios or paying the same price for it. This is what is relevant for us as shareholders.
Aswath Damodaran, a professor at New York University's Stern School of Business, would have liked to have seen it in could not have formulated his blog better:
The stock-based compensation may not represent cash but it is so only because the company has used a barter system to evade the cash flow effect. Put differently, if the company had issued the options and restricted stock (that it was planning to give to employees) to the market and then used the cash proceeds to pay employees, we would have treated it as a cash expense.Aswath Damodaran
So what is Damodaran telling us here? While it is no doubt correct that stock-based compensation is not a cash expense, that is only because companies have found a way around the effect. If a company were to do a capital raise and use the proceeds from it to pay its employees, we would treat it as a cash expense. In this case, many shareholders would probably raise their eyebrows at least once and wonder whether this is what they want. Warren Buffet, with his usual dry sense of humor, is heading in the same direction:
"If you're a CEO and subscribe to this 'no cash-no cost' theory of accounting, I'll make you an offer you can't refuse: Give us a call at Berkshire and we will happily sell you insurance in exchange for a bundle of long-term options on your company's stock."Warren Buffett
It becomes even clearer with the following lines:
"When we consider investing in an option-issuing company, we make an appropriate downward adjustment to reported earnings, simply subtracting an amount equal to what the company could have realized by publicly selling options of like quantity and structure. Similarly, if we contemplate an acquisition, we include in our evaluation the cost of replacing any option plan. Then, if we make a deal, we promptly take that cost out of hiding."Warren Buffett
Interestingly, many investors don't look at it that way, because it's a bit more abstract than a capital increase, where money from your own pockets ends up in the pockets of your company's employees. Nevertheless, you should be aware that with every form of stock-based compensation, your share in the company decreases and with it your share in the free cash flow of the company. Thus, a larger share of the cash flows moves into the hands of others and your share decreases in relative terms.
I want to clearly emphasize that this is not a criticism of the form of payment in general, but an explanation of why you should record SBC as a cash flow reducing expense, contrary to purely formal logic. Here I've given you another relatively simple illustration of the effect that occurs as a result of payment in SBC:
How do I calculate the free cash flow?
First of all you calculate the FCF as you like. An intelligent person can say something stupid and a stupid person something intelligent. You should always look at statements and argumentation independently of the author and consider whether it convinces you. If that should be the case here, then I can reassure you: The facts, which seem abstract in themselves, are easy to calculate in practice:
As you can see, you don't even need to treat SBC separately anymore, since we established earlier, using Tesla as an example, that it is already included in EBITDA. Also, don't be surprised that we first subtract D&A and then add it back. This is an auxiliary solution to arrive at NOPAT (Net Operating Profit After Taxes).
Calculation of the FCF at Tesla
In the case of Tesla, you can take the reported figure for operating cash flow as a starting point and then deduct the corresponding capital expenditures in the same way as the company itself does. From this, you only have to subtract the SBC, as these have previously increased the operating cash flow. This is how you arrive at the real free cash flow.
Anyone who is now understandably frowning and thinking "I can't have to deduct another 2.121 billion here," should be aware once again that SBC is in principle nothing more than carrying out a capital increase of 2.12 billion and distributing the proceeds to the employees. The company has simply found a way to structure these expenses as no-cash expenses.
I hope I have been able to explain to you why it makes sense to deduct stock-based compensation from free cash flow and why you should consider it as a real cost for shareholders. If you do not include them in your consideration, you run the risk of overvaluing your share in my opinion. Especially if the SBC are comparatively high. In the end, of course, you decide for yourself how to deal with the issue.
If you are already somewhat advanced in this topic, you will have noticed that I have only dealt with SBC in connection with FCF and have not discussed the influence of unvested options and unvested restricted stock on equity value. That would go beyond the scope here and is rather negligible compared to SBC in general.
If you have any questions or suggestions, feel free to write me in the comments below this article.
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Stock-Based Compensation - Why stock-based compensation also reduces free cash flow
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