Cost of Equity Grants

Investment Analysis Clubs Manlobbi's Descent
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I’ve gotten mixed views on this question as part of analysis posts on company specific boards, so I’m bringing it here to solicit views from this community. I’ve not posted before on this board, so my apologies in advance if I am breaking a norm/rule, or if it is just too basic for this audience.

Should the cost of equity grants to company employees be taken back out of cash flow statements when calculating free cash flow?

I have been doing this (taking the equity grant value back out) for years when I analyze cash flow, but recently had someone suggest I shouldn’t, so I am testing my view. The company in question was in software, a space I haven’t analyzed much. It seems it is normal to take out the cost of equity grants when calculating operating cash flow for software companies. Said another way, when I took that cash back out of the operating cash flow, free cash flow went way down. In the case of the company I was analyzing, equity grants expense made a HUGE difference in cash flow. It felt to me that if all the software companies and software company investors are agreeing to ignore the cost of equity grants, they are participating in a mass delusion, one that makes their businesses look much better when compared to other sectors. But I’m new to analyzing software companies, so it’s probably me.

My thinking for taking the cost of equity grants back out of operating cash flow is because, to keep share count flat, that stock will have to be bought back in the future. This being the situation, there are three outcomes:

Stock goes up - Buying back those stock grants is more expensive than when they were granted. The reduction in cash available to owners is higher than during the quarter the grants were made. Hence, the hit to cash flow is larger than what was taken out of the operating cash flow during that quarter.

Stock price is flat - Buying back those stock grants costs the same as when they were granted. Cash effect is the same as what was taken out of the operating cash flow during the quarter.

Stock price goes down - Buying back those stock grants costs less than the value when they were granted. Cash flow effect is lower than what was in the operating cash flow during the quarter.

The last of these three scenarios isn’t sustainable, because employees will eventually want something else (like cash) instead of equity grants, or they will want larger equity grants. The first option, the one growth investors are hoping for because the stock price is going up, means that the cost of equity grants under-calls the actual effect on share dilution, because the stock is more expensive to buy back in the future.

Because nobody knows the future of any company’s share price, it seems the best option is just to take the value of equity grants back out of operating cash flow, thus lowering the actual operating cash flow compared to what most companies report.

What am I missing here?

Thanks in advance for any and all thoughts.

-S. Hughes

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In the case of the company I was analyzing, equity grants expense made a HUGE difference in cash flow. It felt to me that if all the software companies and software company investors are agreeing to ignore the cost of equity grants, they are participating in a mass delusion, one that makes their businesses look much better when compared to other sectors. But I’m new to analyzing software companies, so it’s probably me.

Most US firms use GAAP accounting, but some use IFRS. The equity grant under IFRS used based around “IFRS 2 Share-based Payments” which you can look up. The company has to measure the fair value of the equity instruments granted at the grant date (if there is no market price, the so called “fair value” is estimated based on an arm’s length transaction with someone knowledgeable and wanting to trade). For GAAP, stock based compensation is shown as a non-cash expense on the income statement:
https://www.wallstreetprep.com/knowledge/stock-based-compens…

It is not shown on the cash flow statement, but I don’t think it should be in any case, because that is the whole point of stock based compensation - it allows the company to pay employees without changing the cash holdings. You are absolutely correct, though, that it is true economic loss to the owners, and so it should be expensed, which it is, in the earnings.

(As a mental experiment, if you wanted to compensate for the share dilution by buying back the same amount of stock (so shares outstanding remained unchanged) then you would be using up cash, which just demonstrates that there is a theoretical cash loss if the company was to not dilute its shares whilst paying the employees with stock - and this would show up on the cash flow statement. Many companies in fact do this, buying back stock at a similar intensity to the equity grants, and consequently use up their cash).

For software firms that are expanding super-rapidly, wanting to not use up cash, thus paying their upper management ludicrously via stock instead of cash, I don’t have much to say, except the following: The occasional successes (when the company succeeded, employees become ludicrously rich, and the shareholders also do well) seem to “make up for” (by which I mean “avoid shareholders complaints”) the many times the company flops (the employees still received huge compensation largely cashed out along the way, and the shareholders blame their own investing judgement rather than the ludicrous pay). The result is that not enough people complain about the massive employer compensation culture. The combination of these two paths - some companies winning, most failing - allow Wall St bankers to win each time, whilst the company shareholders tolerate the ludicrous compensation, in the off-chance that the company will be exceedingly victorious, but omitting that they usually will fail at some point (much further down the track), and shouldn’t have been paid so much along the way.

Having said that, software (which you brought up) is a truly great industry. I’m not discouraging investing in software firms, but just that the payment culture (especially in banking) more broadly is ludicrous, so software firms follow the similar Wall Street and City of London present cultural norms. Company X observes Y paying their managers more, so they ask their board for their pay to be raised, who are paid to agree. Iterate the previous sentence for a new X and Y value, repeatedly, and calculate the result after many years.

One of the very first things I do when investigating a company is to look at the change in shares outstanding since the IPO, or at least in recent years. If it the shares outstanding are going up, then the calculation of intrinsic value (IV) becomes much more difficult for me, and I usually skip the investment. I thus lose a lot of extremely good investments in this way because often expanding companies do genuinely require (and make excellent use of) massive, and even rather long-term repeated, cash access by continuing to issue shares whilst chasing a major long-term opportunity. Amazon used this method to bring in incredible amounts of cash for a long, long time, whilst not making money, and then in the end making a lot of money - but it is far harder to identify those that will make sensible investments, and those that are just spending the cash with a good story.

Sometimes, you only need a good story though, which brings up the next paragraph.

In addition to share dilution to pay staff, the share dilution is also often used by software companies to simply raise cash for operations. This has worked extremely well in the past - where the company trades far above intrinsic value. Allow me to explain, and hang in there because this is weird (and it is rare to meet an investor that understands it, in fact I have yet to meet or read about any such investor). You can form a company that has a good story, with the help of a reputable banker, issues shares above intrinsic value to raise cash, whilst having no operations of importance (other than broadcasting the story). You can do this indefinitely, and actually increase the intrinsic value indefinitely by doing so, provided the quote remains above intrinsic value as the cash is brought in by using shares above IV. Such a company could have no operations at all, but just trade consistently at, say 2 x cash, and it can continue to issue shares at 2 x cash if the market is confident enough about its prospects. To repeat, the intrinsic value (not only the quote) will rise indefinitely, even without any operations. It only needs a good story to make investors believe that the quote should be 2 x cash, and then keep in issuing shares as aggressively as it can get away with. This is hard to believe, but you can simulate the concept with a spreadsheet fairly easily. Keep the income near zero, (or some small loss to pay for hyped marketing and a charismatic CEO), have a good IPO for at least $1 billion in initial cash, and then keeping issuing shares to bring in more cash and set the price at some multiple of the cash holdings. Eventually it will pass $10 trillion in market cap (and have cash holdings of $5 trillion), and still have no operations.

  • Manlobbi
13 Likes
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Hi Manlobbi. Thank you for your detailed response. Here are a couple comments on what you have posted.

It is not shown on the cash flow statement, but I don’t think it should be in any case, because that is the whole point of stock based compensation - it allows the company to pay employees without changing the cash holdings. You are absolutely correct, though, that it is true economic loss to the owners, and so it should be expensed, which it is, in the earnings.

Most of my analyst experience is in semiconductors. Companies in this sector use stock based compensation widely, so I am used to seeing it in every cash flow statement. You can take a look at Intel as an example, but every semi company I’ve looked at has it as an item on their cash flow statement. I suspect these companies are the exception in the investing universe, which is why I took it as baseline that all cash flow statements include equity compensation. I took a look at a couple of non-tech companies - Costco and Mastercard - and both have stock-based compensation as an item on their cash flow statements, so maybe I am missing the meaning of your comment above.

(As a mental experiment, if you wanted to compensate for the share dilution by buying back the same amount of stock (so shares outstanding remained unchanged) then you would be using up cash, which just demonstrates that there is a theoretical cash loss if the company was to not dilute its shares whilst paying the employees with stock - and this would show up on the cash flow statement. Many companies in fact do this, buying back stock at a similar intensity to the equity grants, and consequently use up their cash).

Yes, this is the way I prefer to think about it. It is simple and requires no assumptions from me about future share price. Some companies I follow state their objective with buy-backs is only to offset dilution from grants. I like it when companies do this. ASML is an example of a company who is forthright about the effect of stock grants on shareholders. Others are “opportunistic” and use it as a way to return cash to shareholders.

For software firms that are expanding super-rapidly, wanting to not use up cash, thus paying their upper management ludicrously via stock instead of cash, I don’t have much to say, except the following: The occasional successes (when the company succeeded, employees become ludicrously rich, and the shareholders also do well) seem to “make up for” (by which I mean “avoid shareholders complaints”) the many times the company flops (the employees still received huge compensation largely cashed out along the way, and the shareholders blame their own investing judgement rather than the ludicrous pay). The result is that not enough people complain about the massive employer compensation culture. The combination of these two paths - some companies winning, most failing - allow Wall St bankers to win each time, whilst the company shareholders tolerate the ludicrous compensation, in the off-chance that the company will be exceedingly victorious, but omitting that they usually will fail at some point (much further down the track), and shouldn’t have been paid so much along the way.

This is quite helpful and makes sense to me as an explanation for the behavior and commentary I’ve seen.

One of the very first things I do when investigating a company is to look at the change in shares outstanding since the IPO, or at least in recent years. If it the shares outstanding are going up, then the calculation of intrinsic value (IV) becomes much more difficult for me, and I usually skip the investment. I thus lose a lot of extremely good investments in this way because often expanding companies do genuinely require (and make excellent use of) massive, and even rather long-term repeated, cash access by continuing to issue shares whilst chasing a major long-term opportunity. Amazon used this method to bring in incredible amounts of cash for a long, long time, whilst not making money, and then in the end making a lot of money - but it is far harder to identify those that will make sensible investments, and those that are just spending the cash with a good story.

Looking at share count over the past few years (at least) is the step I’ve added to my analysis process to deal with share-based comp. If a company/management team has a history of buying back stock well, as measured by meeting their objective, then I adjusted cash flow accordingly. If a company seeks to offset dilution only and are effective historically in doing that, then I take out the value of buy-backs from free cash flow. If they are opportunistic in their buy-backs, and have a track record of repurchasing when the stock price is well below intrinsic value, then I consider buybacks differently, depending on the magnitude and the trend in share count. Applied Materials is an example of a company that has been good at buying back lots of their own stock when the price was low. The cyclicality of semiconductors makes this opportunity bigger in that industry.

Sometimes, you only need a good story though, which brings up the next paragraph.

It is astounding how much cash can be gathered up from investors on the basis of a good story alone. I’ve recently read books on WeWork and Uber, and a commonality between those two companies is they both had founders who were so good at raising cash from investors with their story that they built operations with cultures that were vastly wasteful of money, because it was so easy for them to just go raise more. This isn’t as extreme as the thought experiment you described, but it made me think of them, and how surprising it is that there is so much money at the disposal of investors who can be convinced by a good story alone. Maybe I am too, and it just takes a different kind of story to convince me. :slight_smile:

-S. Hughes

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I took a look at a couple of non-tech companies - Costco and Mastercard - and both have stock-based compensation as an item on their cash flow statements, so maybe I am missing the meaning of your comment above.

In accounting language, stock based compensation expense represents a non-cash expense. So the cash flow statement, accounting adds the expense to operating cash flow. It is done this way because the cash flows is derived from the reported net income (which includes the non-cash expenses) so you see an extra line on the cash flow calculation for “stock compensation” (or it might just be “non-cash expenses” more widely without specifying the stock compensation, but it will still be accounted for) has to be added back in.

Look at it this way - this is conceptual only to just clarify the relation of earnings, non-cash and cash expenses.

  1. Net income = (cash income) + (non-cash income) - (cash expenses) - (equity grants and other non-cash expenses)

  2. Cash flow = (cash income) - (cash expenses)

But rather than calculated as above, cash flow is instead derived from the earnings, and then taking out the parts of earnings not related to cash:

  1. Cash flow = (net income) - (non-cash income) + (equity grants and other non-cash expenses)

You can reconcile these three above together mathematically, and think of cash flow conceptually simply as 2, but keep in mind it is calculated as 3.

If you ran a small business, you would calculate the cash flow in a more common-sense manner by looking at the changes in your single bank account (2 above instead of 3), but as it happens they do it in this complicated way, partly as they have hundreds of bank accounts, and want to (in a sense, artificially) make sure the accounting matches up between the cash flow and income statements. When you are seeing “stock compensation” in the cash flow, notice that it is a positive number for the cash flow (despite being an expense) since it was subtracted early for the reported earnings.

  • Manlobbi
6 Likes
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Thanks for the extra explanation Manlobbi. I didn’t make myself clear that I understand why and how equity grants to employees are accounted for. Your first post was most helpful, to help check my thinking on equity grants.

I’ll describe my view more succinctly than my earlier post. Stock-based compensation is costed against earnings for companies following GAAP. But it is a non-cash expense. Thus, it is added back in within the operating income calculation on the cash flow statement, to bridge between income (which subtracts the value of equity grants from earnings), and operating cash flow. I don’t disagree with any of this as the subtraction in the operating cash flow section became necessary when the decision was made to “expense” stock grants and stock options out of earnings, following Enron, etc.

My question came from the backbone of how I analyze companies, which is to estimate the cash flow each quarter that would be available to me if I owned all the equity of the company. My view is any stock buy-backs that offset dilution should be subtracted from my “owner’s” cash flow, because it is needed to buy back stock I granted to employees instead of cash. It is really just cash round-tripping through the public equity markets, with the hope that more comes back in to the employee when they exercise the grant than went out when the company granted the equity to the employee.

Okay, that was longer than my earlier explanation. Hopefully it is different in a way that is helpful to understand how I think about this topic.

-S. Hughes

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My view is any stock buy-backs that offset dilution should be subtracted from my “owner’s” cash flow

I understand this is your central idea, and yes, you are quite right about this, but it just a case of how one is framing the interpretation in one’s mind. You want to use the accounting figures (cash flow, net income, net equity, etc) of course to “look through the accounting” and understand what is actually happening in the company, and it is very good that you pay a lot of attention to the stock option expense (which is a way of giving your company away to your employees less conspicuously, but equally quantitatively, than paying them cash). Just keep in mind that the stock option expense is, as you have said, accounted for in the net income (especially if net income is normalised over several years which we always do with the Manlobbi Method anyway).

The fact that the cash flow doesn’t show the non-cash costs, but very real costs, to a business, does show one of its big limitations. But it is only what is supposed to be - the change in the actual cash position of the company. I don’t pay as much attention to the cash flow as others do, because the non-cash income and expenses are for the most part “economically” very real. As you are indicating, you can add/remove cash by means of buybacks or issuances, or swap cash with liquid equity assets, etc, which can all be economically neutral but have huge + or - impacts on the cash position that simply don’t matter.

Stock options are supposed to create a higher degree of motivation than a salary, because employees have “skin in the game”, but I expect it is far more important to just the corporate culture respectful and interesting for employees (requiring more management skill though) than relying one dimensionally on greed.

  • Manlobbi
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the many times the company flops (the employees still received huge compensation largely cashed out along the way, and the shareholders blame their own investing judgement rather than the ludicrous pay)

This basically describes the modus operandi of most small mining companies and the many bag-holders who brave this sector

Smufty - and sometimes you get lucky…

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As someone who received a significant portion (20-25%) of my compensation over my career in either stock grants or options, I can say it is an effective retention tool. It didn’t do much for me as far as motivating me to do more at work because I thought I would see it in the value of my shares. I didn’t have any illusions that I could make a measurable difference in a $60B enterprise, at least one that could be measured in share price movement.

-SH

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I was often stimulated by Cisco’s use of stock to pay expenses back in the 1990’s. Often the “value” of the use of stock exceeded sales.

Of course it is now some 20 plus years later and that “stock” of Cisco sells for less than half its high flying quote of yesteryear.