What Is Stock-Based Compensation? Is It Good or Bad?
Stock-based compensation (SBC) can be a double-edged sword. While it can effectively align employees' interests with shareholders and help companies conserve cash, it can also dilute earnings per share (EPS) and obscure the true profitability of a business. For investors, the critical question is: Is SBC bad? The answer isn't straightforward. While SBC offers clear benefits, it also presents risks that can negatively affect shareholders. This article will explore how SBC can be detrimental, how it impacts financial metrics like EPS, and how investors can adjust stock valuations to account for SBC’s effects.
What Is Stock-Based Compensation?
Stock-based compensation refers to the practice of rewarding employees, executives, and directors with company stock or stock options. The most common forms of SBC include:
Stock Options: These give employees the right to purchase company stock at a predetermined price, known as the exercise or strike price, after a certain vesting period.
Restricted Stock Units (RSUs): RSUs are shares granted to employees once they meet specific performance targets or tenure requirements.
Employee Stock Purchase Plans (ESPPs): ESPPs allow employees to purchase company stock at a discounted price through payroll deductions.
Performance Shares: These are shares awarded to employees if certain performance milestones are achieved.
How Stock-Based Compensation Can Be Detrimental
While SBC has its advantages, it also comes with several drawbacks that can be harmful to shareholders and the company's perceived value:
Dilution of Shareholder Value: One of the most significant risks of SBC is the dilution of shareholder value. When employees exercise stock options or when RSUs vest, new shares are issued, increasing the total number of outstanding shares. This dilution reduces the ownership percentage of existing shareholders, which can lead to a decrease in the stock's price per share. For long-term investors, this dilution can erode the value of their holdings.
Impact on Earnings Per Share (EPS) or any other per-share metric: EPS is a crucial metric that investors use to gauge a company's profitability on a per-share basis. Since EPS is calculated by dividing net income by the number of outstanding shares, an increase in shares due to SBC will lower EPS, assuming net income remains unchanged. This dilution can make the company appear less profitable, which can negatively impact investor sentiment and the stock price.
Let's walk through a quick example to illustrate how stock-based compensation (SBC) can lower Earnings Per Share (EPS) by increasing the number of outstanding shares.
Scenario Setup:
Net Income: $1,000,000
Initial Shares Outstanding: 1,000,000 shares
Stock-Based Compensation: Assume that 100,000 shares are issued as part of SBC during the year.
Misleading Profitability: SBC is an expense that companies must recognize on their income statements, reducing net income. However, because it’s a non-cash expense, some companies and analysts may downplay its impact, focusing instead on adjusted earnings figures. This practice can be misleading, as it obscures the true cost of compensating employees and the actual profitability of the business.
Incentivizing Risky Behavior: When a significant portion of compensation is tied to stock performance, employees and executives might take on excessive risks to boost the stock price in the short term. This behavior can lead to long-term instability and potential financial issues for the company.
Perceived Overvaluation: Investors often use EPS and other earnings-based metrics to determine a company’s valuation. Lower EPS due to SBC can inflate valuation ratios like the Price-to-Earnings (P/E) ratio, making the company appear overvalued. This perceived overvaluation can deter potential investors and lead to a decrease in the stock’s market price.
How SBC Affected Palantir’s Per-Share Results
Here’s a real-life example that will show you how stock-based compensation can sneakily affect a company’s per-share results.
Below is Palantir’s revenue trend over the past few years.
Now, let’s look at the past three years of revenue growth. Finbox states that PLTR’s revenue CAGR for the past three years (ending in Fiscal 2023) is 26.7%. Here’s where it gets interesting. If you take a look at its revenue per share CAGR over the past three years, it comes out to 17.7%. This means that the higher share count due to dilution from SBC affected the metric by nine percentage points.
That’s a big deal, especially for people who have historically looked at PLTR as a high-growth company. Yes, it is a growth stock, but the growth is notably slower when looking at it from a per-share perspective.
Take a look at how its share count has grown over the past few years.
Palantir's share count
Nonetheless, the good news for PLTR stock investors is that the company is continuing to grow while lowering its stock-based compensation expense, as you can see below. This is a good sign to look for. Another thing to consider is that perhaps Palantir wouldn't have grown as much as it did in the past few years if it hadn’t been for incentivizing employees via SBC. So, there’s a lot to think about when analyzing this type of company, and investors need to weigh the pros and cons.
Palantir's stock-based compensation
Adjusting Stock Valuations to Reflect SBC
Given the potential downsides of SBC, investors need to adjust their valuation methods to account for its impact. Here are several ways to do that:
Adjusting Free Cash Flow: One conservative approach is to remove the impact of SBC from the company's free cash flow (FCF). That’s because stock-based compensation expense is not included in the free cash flow calculation (SBC gets added to FCF, making FCF higher). By subtracting the SBC expense from FCF, investors can arrive at a more accurate and conservative measure of the company’s cash-generating ability. This adjusted FCF can then be used in discounted cash flow (DCF) models to provide a valuation that reflects the true cost of compensation. For instance, if FCF is $500 million and SBC is $100 million, the adjusted FCF figure would be $400 million ($500M - $100M).
Diluted EPS Analysis: Instead of focusing on basic EPS, investors should examine diluted EPS, which includes the potential impact of all convertible securities, including stock options and RSUs. Diluted EPS provides a clearer picture of the potential dilution and its effect on profitability.
Adjusted Earnings Multiples: When using valuation multiples like the P/E ratio, consider using adjusted earnings that include the full impact of SBC. This approach helps to avoid overvaluing a company by using inflated earnings figures that do not fully account for compensation expenses.
Analyzing Shareholder Dilution: Investors should closely monitor the rate of share issuance and dilution over time. A company that consistently issues large amounts of stock options or RSUs may experience significant dilution, which can negatively impact long-term shareholder value. Adjusting valuation models to account for expected future dilution can help provide a more accurate assessment of the company’s value.
Scenario Analysis: Conducting scenario analysis by modeling the impact of various levels of SBC on future earnings and share dilution can help investors understand the range of potential outcomes. This analysis can provide insights into how sensitive the company’s valuation is to changes in SBC practices.
Is Stock-Based Compensation Really “Bad”?
The potential drawbacks of SBC do not necessarily make it inherently "bad," but they do require careful consideration and management. Companies that use SBC must be transparent about its impact on financial statements and work to mitigate its negative effects (some companies mitigate them with stock buybacks). For investors, understanding the complexities of SBC and adjusting valuation models accordingly is essential for making informed investment decisions.
While SBC can dilute EPS and obscure profitability, it also aligns employee incentives with shareholder interests and conserves cash. The key is to strike a balance—ensuring that SBC is used in a way that drives long-term value without eroding shareholder returns.
Conclusion
Stock-based compensation is a powerful tool that, when used appropriately, can drive growth and align the interests of employees and shareholders. However, it also comes with significant risks, including dilution of EPS, misleading profitability metrics, and the potential for incentivizing risky behavior. For investors, understanding how SBC impacts financial metrics and adjusting valuations to reflect its true cost is crucial for making informed decisions. By accounting for the effects of SBC, investors can better assess a company’s true value and make smarter investment choices.
