At the start of 2023, Fundsmith Equity (B41YBW7) boss Terry Smith went to town over the habit of some companies to strip out the impact of share-based compensation (SBC) from reported profits.

‘I suspect the most pernicious effect of adjusting profits to exclude the cost of share-based compensation occurs when the management start to believe their own shtick and mis-allocate capital based upon it,’ the fund manager said in his 2022 letter to shareholders.

We don’t have the scope in this feature to get into the detailed nitty gritty of SBC, but we can try to give readers an outline of why Smith, and others, believe that excluding SBC results in the potential for significant overvaluation of equities.

Enterprise software firm Salesforce (CRM:NYSE) is one example of a stock which has attracted significant criticism for excluding its significant SBC from headline profit.

WHAT IS SHARE-BASED COMPENSATION

SBC is the practise of handing company directors, senior management and even the general workforce, shares or options to buy shares in the business as part of their remuneration. It is common in the US, particularly in innovation-heavy industries like technology and healthcare and is becoming increasingly used in the UK and Europe too.

There are very sensible reasons why. SBC schemes:

allow young, fast-growing companies to attract high quality talent even if they couldn’t afford to pay competitive cash salaries;

contribute to employee loyalty since those employees usually have to remain with the company for a number of years in order for their stock compensation to vest;

can align employees’ interests with those of the company’s owners, its shareholders.

While not as immediately obvious as salary expenses, SBC costs don’t just disappear, they just transfer the economic cost to shareholders since issuing stock, either immediately or at some point in future, has the very real negative impact of diluting the value of each individual share.

Microsoft vs Intuit – The impact of excluding SBC

In January Fundsmith’s Terry Smith offered up the example of Microsoft (MSFT:NASDAQ) and accounting software company Intuit (INTU:NASDAQ).

The former included share compensation while the latter didn’t. Adding back roughly $1.8 billion of compensation expenses to make an apples-to-apples comparison pushed Intuit’s price to earnings multiple to 43 times from 28 times.

This meant Intuit trades at a 72% premium to Microsoft which wasn’t apparent if investors use analysts’ earnings forecasts.

ARGUING THE SBC EXCLUSION VIEW

The main argument for excluding SBC costs seems to be because option awards are not cash items. Yet there are multiple non-cash items that flow though profit, such as revenues from sales on credit, depreciation and amortisation and pension costs, for example. If they are included, why not SBC costs?

Also, the only way to offset the potential dilution of new shares is for the company to buyback the same number it issues to employees, using cash.

For example, if a company issues 1,000 shares via stock option grants, then it needs to buyback and cancel 1,000 shares to avoid any dilution. But to do this buyback requires real cash, so that stock compensation has just become a real cash expense again. The cash cost has just been transferred to a different part of the income statement – but it’s still there.

The other option is for a company to just kick the can down the road, dilute shareholders now, and hope there is sufficient cash generation in the future to fund the buybacks needed to offset past dilution, or to pay the cash salaries. This is the option chosen by many companies.

But whichever way a company chooses to approach this, there just isn’t a way of escaping the real cost of labour. A company either pays employees in cash now, pays them in stock and spends cash to purchase equivalent shares later, or it makes the shareholders pay through dilution.

Another argument for stripping out SBC costs is because valuations are subjective and rely on valuation methodologies that depend on assumptions on the risk-free interest rate and share price volatility. Smith accepts this but argues that things like depreciation also use assumptions and estimates as well, where the expense is calculated based on the estimated useful lives of assets, for example.

‘A question we would pose to companies drawing on this argument is, if you have no idea what the (say) stock option is worth, how do you decide how many options to award to your employees,’ says Liberum.

Liberum is right, if a company has no idea about the value of the options they are handing out to staff, then they shouldn’t be awarding stock options at all.

CASH FLOW DISTORTIONS

What about cash flow? Cash flow based stock analysis is often lauded as the most defensive, grounded, form of running the rule over a company. The mantra goes that investors should always look to cash flows because earnings can be manipulated, but cash doesn’t lie. That is mostly true but while cash may not lie, it can mislead you.

The problem is that stock-based compensation inflates reported cash flow numbers. Consider that many companies choose to pay employees in stock without buying back shares to offset dilution, so technically there has been no cash out the door.

Under GAAP (generally accepted accounting principles), SBC is added back in the cash flow from operating activities, which in turn is used to work out free cash flow. Some researchers and commentators argue that share-based compensation should be reclassified from the operating activities section to the financing activities section of a cash flow statement for analytical purposes.

‘We agree,’ says Fundsmith’s Smith. ‘The decision to fund compensation to employees with shares rather than cash is a financing decision rather than one pertaining to the operations of a company. As such, a measure of cash flow from operating activities that does not benefit from adding back share-based compensation is likely more reflective of the ongoing cash generation of a company.’

This variability in treatment of SBC costs in earnings distorts comparisons with peers and it can make cash flow valuation metrics, such as EV/EBITDA and PE (enterprise value to earnings before interest, depreciation and amortisation and price to earnings) look more attractive than they are.

The key thing for investors to think about is: what is going on with the underlying business? What are the accounting numbers not showing me? It is always worth considering the business itself, not just the numbers it produces.

The author has a personal investment in Fundsmith Equity referenced in this article.

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