In this tutorial, you’ll learn the proper treatment for Stock-Based Compensation in a DCF when projecting a company’s Unlevered Free Cash Flow - and you’ll see why it should be treated as an actual cash expense, not a non-cash add-back.
By breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers"
Table of Contents:
1:52 Why It’s Hard to Define Unlevered FCF in Practice
5:28 Why Stock-Based Compensation Should Be Treated Differently from Depreciation & Amortization
11:49 What Stock-Based Compensation “Costs”
15:49 Advantage and Disadvantage of Listing SBC as a Cash Expense in a DCF
17:17 Summary
To understand the concept of Unlevered Free Cash Flow, we recommend thinking about a company’s Cash Flow Statement itself, and then modifying it to remove non-recurring and optional items, and anything related to financing activities (such as net interest expense, debt principal repayments, share issuances/repurchases, etc.).
For some items, this is fairly simple: for example, everyone agrees that you add back Depreciation & Amortization when calculating Unlevered FCF, since they represent the expense recognition of cash payments spent on PP&E and Intangible Assets in prior periods.
The problem, though, is that there are often “borderline” items where it’s not clear exactly what to do, or where the treatment is controversial.
This often happens with the non-cash adjustments section in the FCF calculation, because not everyone agrees on which charges should be kept in, which should be removed, and what everything actually means.
Why Stock-Based Compensation is Very Different from Depreciation & Amortization
Some people argue that Stock-Based Compensation should be added back when calculating Free Cash Flow because it’s a non-cash expense, just like D&A.
The problem is it’s not!
SBC is fundamentally different from D&A because SBC results in additional shares outstanding in the future, which dilutes existing shareholders in the company.
Also, unlike with D&A, there is no “upfront cash payment” that is simply being amortized over time and recognized as an expense.
Think about it like this: let’s say you have a house worth $10 million, and you pay someone to manage it for you.
Instead of paying him a cash salary of $100,000 per year over 5 years, you award him with a 1% ownership stake in the house each year. By the end, he therefore owns 5% of the house.
When you go to sell the house, you now only receive $9.5 million - not $10.0 million - because someone else owns more of it.
It’s the same with Stock-Based Compensation: if you simply add it back as a non-cash expense, you’re getting a “free lunch” because you’re not reflecting any cash payouts associated with it, nor are you reflecting the additional shares that get created.
Note that this issue with the additional shares matters even for private companies because private companies still have shares outstanding - so SBC still makes the same impact on them.
So What Does SBC Really Cost?
There are 2 ways to estimate the “cost” of Stock-Based Compensation.
In method #1, you could attempt to estimate the number of shares that get created in the future, based on the company’s share price, the terms of the stock-based compensation, and historical trends.
The problem is that this requires a lot of guesswork since you have to predict a company’s future share price, the exercise prices of options issued in the future, and so on.
So we prefer method #2: simply count Stock-Based
Compensation as a normal cash expense, just like paying salaries or benefits to employees.
This is also not exactly accurate, but at least it is based on actual historical financial information, not guesswork about the future (as much).
It may not be accurate because the actual # of shares created in the future might differ from the numbers implied by the SBC issued in a given year; but given the alternatives, this is the best way to do it.
One Final Note: No, we don’t treat SBC like this in our other tutorials, videos, and courses. It is in the process of being changed over, and newer versions of these will reflect this treatment.
RESOURCES:
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