How Should We Measure the Dilutive Impact of Stock-Based Compensation?

Many technology companies nowadays use stock-based compensation to reward managers and employees.

Some even pay as much as 80% of executive pay in stocks or options. I’m personally a fan of stock-based compensation for a few reasons.

Why I’m a Fan of Stock-Based Compensation

For one, stock-based compensation is not a cash expense. Cash is the lifeblood of a company and is vital for a fast-growing business.

Second, stock-based compensation aligns management’s interests with shareholders. Executives and employees become shareholders themselves who are incentivised to see the stock perform well.

In addition, companies may pay executives through stock options or restricted stock units that vest over a few years. With a multi-year vesting period, executives are incentivised to see the stock do well over a multi-year period, which aligns their interests with long-term shareholders.

All these being said, stock-based compensation does create a headache for analysts: It leads to a mismatch between the company’s profit/loss and its cash flow.

Stock-based compensation is recorded as an expense in the income statement but is not a cash expense. As such, companies who use stock-based compensation end up with higher cash flow than profits.

Why Adjusted Earnings Is Not Good Enough

To account for the difference, some companies may decide to provide adjusted earnings. This is a non-GAAP (generally accepted accounting principles) accounting method that adjusts earnings to add back the stock-based compensation and other selected expenses.

The adjusted earnings figure is closer to the company’s actual cash flow. But I don’t think this is the best method to measure the impact of stock-based compensation.

Adjusted earnings do not take into account the dilutive impact of stock-based compensation.

Free Cash Flow per Share May Be the Best Metric To Use

So how do we best measure the impact of stock-based compensation? Amazon.com’s founder, Jeff Bezos once said:

“Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize.”

I completely agree. With the growing use of stock-based compensation, earnings per share is no longer the most important factor. Free cash flow per share has become the more important determinant of what drives long term shareholder value.

This takes into account both non-cash expenses and the dilutive impact of share-based compensation.

By comparing a company’s free cash flow per share over a multi-year period, we are able to derive how much the company has grown its free cash flow on a per-share basis, which is ultimately what shareholders are interested in.

Ideally, we want to see free cash flow growing much faster than the number of shares outstanding. This would lead to a higher free cash flow per share.

Conclusion

To sum up, stock-based compensation is a good way to incentivise managers to act on the interests of shareholders.

However, it creates a challenge for analysts who need to analyse the performance of the company on a per-share basis.

In the past, earnings used to be the best measure of a company’s growth. But today, with the growing use of stock-based compensation, free cash flow per share is probably a more useful metric to measure a company’s per-share growth.

By measuring the year-on-year growth in free cash flow per share, we can derive the actual growth of a company for shareholders after accounting for dilution and any other non-cash expenses.

This article first appeared on The Good Investors and is part of a content syndication agreement between The Good Investors and Seedly.

The Good Investors is the personal investing blog of two simple guys, Chong Ser Jing and Jeremy Chia, who are passionate about educating Singaporeans about stock market investing.

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