Thursday, February 13, 2014

Stock-based Employee Compensation: Value and Pricing Effects

In my last post on Twitter, I argued that the firm's claim that it actually made money in the last quarter of 2013 was fiction. That may sound like an exaggeration, since the company is transparent about the adjustments that it made to get to its adjusted numbers and the practice it uses is widespread not just among companies, trying to better a better face on their operating results but also among analysts who track these companies. In particular, the biggest factor in the earnings transformation was the company's treatment of stock-based employee compensation, which was added back to arrive at the adjusted earnings.

From GAAP Earnings to Adjusted Earnings: The Twitter Adjustments
To get from their reported losses to profits and from reported EBITDA to Adjusted EBITDA, Twitter made the following adjustments:

Twitter's adjustments shifted a fairly substantial loss exceeding half a billion into both net profits ($9.774 million) and positive EBITDA ($44,745) in the fourth quarter.

The dominant add-back in both adjustments is the stock-based compensation of $521.2 million and while it may be sanctioned by accountants, I am struggling with the logic of why. Attempting to give Twitter, the benefit of the doubt, the rationale for adding back the expense to get to adjusted EBITDA is that it a non-cash expense (though I will take issue with that claim later in this post), but that cannot be the rationale for adding it back to get to net profit, since net profit is an accounting earnings number, not a cash flow. One possible explanation that can be offered (and it is a real stretch) is that Twitter views stock-based compensation as an extraordinary expense that will not recur in future years and that the adjusted net income should therefore be viewed as a measure of continuing income.  I will believe this explanation, if I see Twitter stop using stock-based compensation, but I don't see how they can afford to. They have a lot of employees, some of whom are highly paid, and they cannot afford to pay them cash. The other explanation is that the adjusted net income is being divided by the fully diluted number of shares outstanding, which includes the shares that are being offered as compensation. This "consistency" argument is used by many analysts, and while it may offer the fig leaf of matching , it is an extremely sloppy way of dealing with stock-based compensation.

Stock-based Employee Compensation: A long & tortured road
To understand where we are with stock-based compensation, let's start with a quick review of its history. While businesses with cash flow problems have always used equity based compensation to attract employees, there was a quantum leap in the use of stock-based compensation by publicly traded companies in the 1990s, driven partly by bad legislation (limiting executive compensation), partly by the entry of young, technology firms into the public market place and partly by bad accounting practices. 

In particular, accounting rules allowed companies to grant options to employees and show no cost, at the time of the grant, if the options were at the money. Not surprisingly, companies treated as options as free currency and gave away large slices of equity in themselves to employees (and, in particular, to the very top employees), while claiming to be spending no money. If and when the options were exercised later, companies would report a large expense (reflecting the difference between the stock price at the time of the exercise and the exercise price) and show that expense either as an extraordinary expense in the income statement or adjust the book value of equity for it. 

After a decade of fighting to preserve this illogical status quo, the accounting rule makers finally came to their senses in 2006 and changed the rules on accounting for option grants. Companies were required to value options, as options, at the time of the grant and expense them at the time (with the standard accounting practice of amortizing or smoothing out softening the blow). This is the law that is triggering the large stock-based employee option expenses at Twitter and other companies like it, that continue to compensate employees with equity. It is worth noting that the change in the accounting law has also resulted in many companies moving away from options to restricted stock (with restrictions on trading for a few years after the grant), since there is no earnings benefit associated with the use of options any more.

Stock-Based Compensation: Expense or not? Operating or Capital? Cash or non-cash?
Stock-based compensation is embedded in  many US corporations and it is increasingly finding a place in companies that are incorporated in other countries as well. Two decades after they became part of the landscape, there still seems to be a lot of confusion about their place in the financial statements and how exactly they should  be viewed.

1. Is it an expense?
This is an easy one. Of course! If you look at why and where companies use stock-based awards, it is more used early in a company's life cycle and it is used to compensate employees. As Warren Buffet is famously quoted as saying, "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And if expenses should not go into the calculation of earnings, where in the world should they go?"

The timing of the expense is also clear. It is at the time of the grant, and arguments that use uncertainty about whether these options will be exercised in the future to justify not expensing them are specious. We are uncertain about almost everything that has to do with the future, but that does not stop us (or should not stop us) from making our best estimates at the time that we encounter them.

2. Is it a capital or operating expense?
This is trickier, since it really depends upon who gets the options and what function they play at the company in question. In the case of Twitter, for instance, the bulk of the options were granted to employees in the R&D department:

An argument can be made that R&D expense is a capital expense, not an operating one, and that it should treated as such. I concur with the sentiment (though I don't know the classification system that Twitter used to determine the breakdown of stock-based compensation). and I did capitalize R&D expenses in my Twitter valuation. However, that does not give you a license to just add back the expense, since capitalizing it will result in an asset that has to be depreciated; see this paper that I have on capitalizing R&D, if you are interested. Thus, if Twitter wanted to use this rationale, it should have added back just the R&D portion of the stock-based compensation and then subtracted out the depreciation on the synthetic asset it creates. 

3. Is it a non-cash expense?
Many equity research analysts seem to think so, but then again, their judgment on a number of fundamental valuation issues remains questionable. Let's be clear on what it is not. It is not an expense like depreciation, which is truly non-cash and should be added back to get to cash flow. It is closer in spirit to an in-kind compensation than a non-cash compensation. To explain my reasoning, let me use an analogy. Let's assume that you own and run a business that has an overall value of $100 million and generates $10 million in annual income. Let's assume that you hire me as your manager and that  my compensation is $1 million and that rather than pay me with cash, you give me 1% of the business as compensation (1% of $100 million is $ 1 million). While you may maintain the fiction that this is a non-cash expense and that your income is still $10 million, you are now entitled to only 99% of that income in perpetuity. In effect, your share of the business is worth less and it will get even smaller over time, if you continue to compensate me with equity.

I would argue that as common stockholders in any company that grants options or restricted stock to its employees, we are in exactly the same position. 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 employees) to the market and then used the cash proceeds to pay employees, we would have treated it as a cash expense.

In closing, then, we have to hold equity compensation to a different standard than we do non-cash expenses like depreciation, and be less cavalier about adding them back. To those analysts who argue that using the diluted number of shares to compute per share numbers will take care of the problem, my response is that it will do so only by accident (as I hope to show at the end of this post).

Stock-based Compensation and Value
In discounted cash flow valuation, the safest way to deal with stock-based compensation is to recognize its two-layered impact on value per share:
a. Continuing Earnings/cash flow impact: If you are valuing a company that is expected to continue paying its employees with options and/or restricted stock, your forecasted earnings and cash flows for the company will be lower than for an otherwise similar company that does not follow the same practice. These lower cash flows will reduce the value of the business and equity today.
b. Deadweight effect of past compensation: If a company has used options in the past to compensate employees and these options are still live, they represent another claim on equity (besides that of the common stockholders) and the value of this claim has to be netted out of the value of equity to arrive at the value of common stock. The latter should then be divided by the actual number of shares outstanding to get to the value per share. (Restricted stock should have no deadweight costs and can just be included in the outstanding shares today).
While it may seem like you are double counting options, by first reducing earnings for their grants, and then again reducing the overall value of equity for outstanding options from the past, you are not. In fact, if a company stops using equity-based compensation after years of option grants, the first effect (on earnings/cash flows) will stop but the second effect will continue until all of the options either expire or are exercised.

If you look at my Twitter valuation in February 2014, you will see both effects in play. Since I don't follow Twitter's practice of adding back stock-based compensation, I forecast losses/negative cash flows for the company for the first few years before the scaling effects kick in: as revenues get larger, employee compensation will become a smaller percentage of those revenues (just like other fixed costs). The value that I get for the operating assets today incorporates these negative cash flows and is thus lower because of the generous stock-based compensation at Twitter. Once I get the value of the operating assets, I deal with the deadweight cost of past option grants by valuing the 42.71 million options outstanding at $2.182 billion, primarily because the options have an average exercise price of $1.84 (well below the current stock price) and subtracting this value from the overall value of equity of $13.6 billion, before dividing by the actual number of shares (including restricted shares) of 555.2 million. 

Stock-based Compensation & Pricing
If you are a fan of using multiples and comparables, you are probably congratulating yourself at this point for having avoided the complications that ensue from stock-based  compensation in intrinsic valuation. However, you would be celebrating too early. All multiples are affected by stock-based compensation, in small and big ways. Assume, for instance, that you are comparing PE ratios across technology firms that are big users of stock-based compensation. At the risk of stating the obvious, the PE is the market price divided by the earnings per share, but the per-share values can be impacted by how they are computed. Assume, for instance, that analysts are computing earnings per share  by adding the stock-based compensation to the stated earnings and then dividing by the fully diluted number of shares and that you are comparing three companies.  All three companies have 10 million shares outstanding, trading at $10/share currently and their GAAP net income is $10 million.  The first pays $ 5 million in cash compensation and uses no stock-based compensation, the second grants 2 million at-the money options with a value of $5 million to compensate employees and the third has set aside 0.5 million restricted shares with a value of $5 million to compensate employees.  The table below computes and compares their PE ratios, using the standard (dilution-based approaches):


Based on this comparison, company C would look cheapest and company A most expensive but only because of the way that we deal with stock-based compensation. In fact, the biases become worse as companies continue to grant options and the disparity between primary and diluted shares grows.

So, what should you do, if you have to use multiples? First, stop adding back stock-based compensation to net income. There is no logical or financial rationale for doing so. Second, stop playing around with the denominator. If there are shares outstanding, restricted or not, count them. If there are options outstanding, value them and add them to the numerator (the market capitalization) and don't adjust the shares outstanding for in-the-money, at-the-money or out-of-the-money options. 
Option-adjusted PE = (Market capitalization + Estimated value of options outstanding)/ GAAP Net Income
The same rationale applies if you are using EV/EBI/TDA or price to book ratios. 

Bottom line
Analysts, accountants and appraisers seem to still be struggling with how best to deal with stock-based compensation, whether in the form of options or restricted stock. I think the answers lie in going back to basics. There are no free lunches and if a company chooses to pay $5 million to an employee, that will affect the value of my equity, no matter what form that payment is in (cash, restricted stock, options or goods). There are reasons why one form may be better for some companies and another for different companies but these should not be cosmetic or based on adjustments (real or imaginary) that companies and analysts may make to earnings and per share values.


  1. Shouldn't the value of options be subtracted from the mktcap when calculating option adjusted PE?

  2. I have a related questions. Why do companies show non-GAAP figures in addition to GAAP? Isn't the whole idea of GAAP to have figures that are comparable and that rely on accepted method. Why do companies insist on showing non-GAAP figures, too? Do you think there's value in the non-GAAP figures, or do companies abuse them to ignore things they dislike about GAAP?

    Maybe you can comment here or write a blog post about this topic. Thanks!

  3. Hi Hin,

    If you subtracted value of options then you would be understating PE ratio and portreying a rosier picture of a company.

  4. Hin,
    The market cap reflects the equity in the common stock and the equity in options is on top of this. Krystian is right. Subtracting the value of the options will only make your company look cheaper, when it is not. As for companies report non-GAAP numbers, it is because investors and analysts actually use them. The fault lies not with the companies but with the rest of us for even paying attention to these numbers.

  5. Hin,
    The market cap reflects the equity in the common stock and the equity in options is on top of this. Krystian is right. Subtracting the value of the options will only make your company look cheaper, when it is not. As for companies report non-GAAP numbers, it is because investors and analysts actually use them. The fault lies not with the companies but with the rest of us for even paying attention to these numbers.

  6. "Many equity research analysts seem to think so, but then again, their judgment on a number of fundamental valuation issues remains questionable"

    Oooh burn... send him to the ICU!

    But in all seriousness, you should do a post on those other questionable valuation judgments.

  7. I'm sorry for the long post, but I don't see anyone talking about this, and if you could at some point, it would be of great service: There is a problem with the combination of stock buybacks and executive compensation: companies are turning 100% of operating cash flow + debt to reduce their number of shares outstanding. Then their compensation targets are dubiously solely based on EPS growth and share price growth. These can be hit if you're buying 15 to 20 percent of shares outstanding annually. Given that the firms know the extreme buyback greatly increases their odds of hitting targets, they are essentially undervaluing the options, and I believe regulators can look at this and decide they undervalued knowingly. When these are executed, the company gets a cash flow from the IRS, sometimes the full accounting cost of compensation is recovered. Furthermore the SEC's opinion is that firms do not have to show all of their shares on the balance sheet, not even in treasury shares. They do not have to disclose them anywhere. They can, and do, have them in plans that are for future issuance for compensation that are not disclosed on the books in any obvious and clear way, but when you do the hard work and compare what went where in their foot notes, you can start to figure out that at some firms it starts to look more like an effort to obfuscate the link between their buyback operations and the executive compensation. As long as companies have a proper plan, they have safe harbor from being accused of manipulating their share price, that happened in 2003, repurchase programs exploded after that. I'll stop there.

  8. Is it reasonable to view stock based compensation as a type of capital? And if it is, how would it affect the discount rate? Presumably it would increase the discount rate as the required return for stock options should be much higher then plain equity? I guess this should have more relevance for tech startups as they are like issuing stock options so much...

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  10. The idea sounds great but I do not think that paying someone in the form of stock is such a good idea.

  11. This is in large part driven by IB tech analysts who frequently use multiple valuations using P/CFOx. Options boost CFFO, so most tech companies do this (e.g. N, CRM [insert your favorite tech company here]). Just look at the trend of [options expense]/ CFFO.

  12. If the employee compensation is based on stock than it should be well calculated with each value and pricing effects.

  13. I want to expand upon what 'End Game' said. We think of technology companies whenever we hear share-based compensation, however it is more prevalent we think.

    For example,I was looking at McDonald's numbers and I found this shocking fact. Over the past 10 years McDonald's earned about 41 Billion in profits, but take a guess on how much the Shareholder's equity has increased? just 1.8 Billion. In other words, just 4% of the Net Income was reinvested into the equity. About 19.6 Billion or 48% was paid as dividends but the remaining 48% was spent on repurchases. But the share count came down only by 268 Million.

    We have a system where the companies get away with paying compensations as stock options but also tout stock repurchases as a shareholder friendly measure.

    This post is a good start

  14. Hi Professor,
    I'm still struggling how after your adjustments, that Company A, B, and C would all come out with a PE of 10 with the double counting. What is the flaw of simply using GAAP income over current shares outstanding (not counting dilution) because from the table above, they will all show PE of 10 if done this way. Thanks!

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  16. I hate to drag such an old post back out, but I was wondering if you would comment on how to correctly incorporate your thinking into measurement of EPS independent of P/E? I work at a company with substantial equity-based comp and while I understand and agree with everything you've written, I'm not sure if we should be using Net Income (including fair value cost of equity comp) divided by basic, diluted or fully diluted shares outstanding in order to get the right number but also avoid double-counting.

  17. A great article on one of the most crucial subjects as far as I see from my professional experience covering tech companies for a long time.

    At present, the sell side community has got totally paralyzed using non-GAAP as a proven and accurate valuation basis. That is useful for creating deals and investment banking business. That also influences the market mindset as most buyers (the worst is so called and popular momentum trading strategy which implicitly admit they do not think themselves at all) are trying to forecast the direction of the "beauty voting".

    Wish this article can be read by more market participants (IB may not be happy though) and the discussion on the practice (for stakeholders) of using non-GAAP to value stock would get more active to bring a right measurement system (or at least the activity toward it) in valuing biotech and tech companies.

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  19. I agree with the fact that Many equity research analysts seem to think so, but then again, their judgment on a number of fundamental valuation issues remains questionable for Intraday Commodity Market Recommendations.

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  22. Great article, the way I looked at it, it's inflating the Contributed Surplus (Shareholder Equities) and deteriorating RE each year during the Vesting Period.

    When the options get exercised, Dr. small amount of cash and Cr. a much larger amount on Common Stock, whereas the deteriorated RE will not be recovered.

    By only looking at net income + stock-based compensation, one is ignoring the fact that deterioration happening in RE... End of the day, although Common Share increased by market value of the options, but the Assets side increased much less (Excise price of the option) per share value decreases...........if not excluding Stock-based compensation, one is assuming RE stays the same, those options will be exercised at market price

  23. But actually you are double counting it. To use prof. Damodaran example: if we don't add back stock-based compensations in all three cases - company A,B,C would have same adjusted net income - $10 million. But with different number of diluted shares. which would give different EPS and P/E. In other words those that appear cheaper would appear more expensive.
    Now imagine company B and C would be doing this every year. Company B would have 12 million shares , next year 14, after that 16, 18 and 20. With same GAAP earnings as company A and without adding stock based compensations it would appear twice as expensive as company A on P/E basis.

  24. Professor, I work at growth fund and struggle with SBC everyday. Thanks for your detailed entry.

    The consistency argument (adjusted net income is being divided by the fully diluted number of shares outstanding) does not hold up arithmatically...Adding same or similary number (SBC and fully diluted share count) to the numberator and denominator of a fraction breaks the equivalency...its just plain arithmatics.

  25. Professor,

    By and large I agree with your discussions on the accounting treatment of options, but I disagree on your views on SBC that are settled in shares. Specifically, I actually agree with the following argument you cited:

    "The other explanation is that the adjusted net income is being divided by the fully diluted number of shares outstanding, which includes the shares that are being offered as compensation."

    Here is the basic rationale. Yes, giving free shares to employees is an expense, but having it affecting both the numerator (i.e. charging to income as expenses) and the denominator through higher share count is double counting, double punishment really. The economic reality is, by suddenly have a higher share count should not change the total amount of reward - net income; the only thing should change is the number of shares that participate in the sharing of that reward. That is, net income doesn't change, but EPS does through dilution. Recently I chatted with a friend about this same topic on Google. Below is what I had to say. Please comment.

    "I want to make a few more points just to clarify. Let me know if you feel bored by this topic, and I'll stop. 1. I'm not assuming the 4 billion SBC all came from 2014. If Google stock grants typically take 5 years to vest, I'm assuming the 4 billion is the collective effect of the portions that were granted during the last 5 years and vested in 2014 and got charged to 2014. Collectively those portions have resulted in 1-2% dilution in a year. 2. The point I have been trying to make has less to do with Google in particular, but more to do with the inappropriateness of the accounting standards in charging SBC expenses to income. For stock options or stock appreciation rights that are expected to settle in cash and do not result in shares being issued, I agree they should be expensed. Otherwise, for all others that are expected to be settled in shares, they shouldn't be charged to income as expenses since share dilution will take care of it in the earnings per share calculation. 3. To make my point, let me use a simplified example. Let's assume we are looking at a company with 100 shares outstanding trading at $10 per share. Further assume it has 10 employees and $100 in net income without any SBC. For simplicity let's also assume the company's tax rate is 0. So it earns $1 a share and trades at PE of 10. Now imagine what happens to its reported net income and earnings per share if the company decides to give every employee 5 free shares, only one being vested in the current year, and the rest being vested in successive years. GAAP accounting requires the company to expense the 10 vested shares at market value for the current year (1x10=10, with 1 share vested for each of the 10 employees), leading to a net income of 100 - 10x10 = 0. That says the company has no income, or equivalently, its management is giving the entire company away! But that's absurd. In reality it's only giving away 10/(100+10)=9% of the company for the current year. Instead of reporting $0 per share in earnings, it should have reported 100/(100+10) = 0.91 dollars in earnings per share after fairly accounting for dilution. After all, the economic reality is that there are now 110 shares for the current year sharing the same $100 in total income. Giving away free shares should only affect share count and earnings per share, not net income, absent taxes."

  26. It is not like the difference between EPS and Diluted EPS is hidden from the public. Every company posts EPS and Diluted EPS at the bottom of their statement of operations. I am not sure if you are trying to explain the difference between the two?

    Companies and investors focus on adjusted data because they are not focused on earnings but on growth. At Twitter revenue growth is based on its ability to attract MAUs and monetize them.

    Personally I like to look at earnings-R&D for my adjustments. Last Fiscal year they would have made about $0.252. Still expensive but they are growing revenue at about 100% per year so I do not have a problem paying $37.

  27. I work in finance and have been quite puzzled by the popular practice of adding back stock-based compensation to EBIT and EBITDA - indeed, if you browse online portals such as Wall Street Oasis, it is taken as a logical necessity to do so. This never made sense to me, and it is gratifying to see Professor Damodaran explain why so.

    However, the main reason I stumbled across this page is because of questions I've been trying to answer while reading Piketty's book - Capitalism in the 21st century. One of the issues Piketty discusses is the rise of the "supermanager" and how incomes at the top of corporate America have risen so drastically in the last 30 years.

    My intuitive thesis is that stock-based compensation may have a large role to play with this phenomenon and I've been scouring the web to see if anyone has attempted to look for positive correlation between the rise in stock-based comp and overall comp to the "supermanagers." What I think could be a particularly interesting phenomenon is that if companies, analysts and the financial world in general are looking at adjusted earnings that exclude stock-based compensation, this only creates a circularity whereby corporate executives can continue to take home larger compensation packages without affecting their "adjusted" bottom lines.

  28. Hello,

    would it also be feasible (as a shortcut) to calculate the "real" PE Ratio not by adding the value of outstanding Options to market cap in the nominator, but rather to use Share Price / EPS calculating EPS based on diluted Shares at the end of the Prior year (in order not to double Count recently awarded share Options)?

    Obviously that's not precise but Option valuation models are not perfect either and data for precise calculation is neither...


  29. Hello Professor,

    thanks for the article.

    One question. Let s assume that the company reports under IFRS 2 and let s assume that the FV at grant is allocated over the vesting period. Let s assume the Valuation Date is during the vesting period, i.e. the net income includes the pro-rata part of the option expenses. If I add the FV of the options outstanding to the Market cap in order to compute a P/E multiple, isn't there some inconsistency between numerator and denominator? Because the numerator does not account for the dilution effect of the option, while we consider some expenses in the NI.

    I look forward to hearing from you.

    Best regards.


  30. Dear Professor,

    My concern is that your explanation of why stock-based compensation is an expense is the same old story and, as the FASB explained it way back when, it is based on tautological reasoning. But, even if we assume that it is a proper expense, your explanation of why it is not the same as depreciation or amortization is quite weak - and you conclude it is different because you say it is. Still, after all that, your argument about why it should not be added back to arrive at adjusted EBITDA is focused on that metric as a performance measure, rather than, what it once was (and more appropriately so), a measure of liquidity. But, once again, even after all that, it is a non-cash expense, despite your tautological contention that it is not.


Given the amount of spam that I seem to be attracting, I have turned on comment moderation. I have to okay your comment for it to appear. I apologize for this intermediate oversight, but the legitimate comments are being drowned out by the sales pitches and spam.