How should SBC be handled in a DCF
Hi Everyone,
I was confused with the treatment of SBC in an unlevered free cash flow DCF:
1) Should it be treated as a non-cash expense and added back? Would I be overstating my equity value after bridging from enterprise value?
2) If I keep track of the number of shares to be issued from the ESOP pool and RSUs for example, couldn't I just divide the equity value from part (1) with the diluted shares outstanding to arrive at the share price?
Thank you and appreciate any feedback on this
Just treat it like a cash expense. You have the right intuition: SBC is future dilution, which needs to be factored in a way.
Do nothing (do not add it back). Also, be careful not to use the company's 'adjusted EBITDA' which 99% of the time adds back stock-based compensation. If you expense SBC and treat it as a cash item, you're already pricing in the future dilution effect from the reduced cashflows.
And no, don't divide the equity value by 'diluted' shares outstanding - this 'adjustment' artificially lowers equity value but does not consider the cash the company receives from the options being exercised (and most certainly do not add back AND use diluted, that will be double counting).
For your first part, agree that SBC results in future dilution, but technically if the employee has not exercise them yet, am I correct to say there is no dilution yet? For example if it only vests after 5 years, would I be overstating the effects of the dilution if I start factoring in the lower cash flows from day 1?
For the second part, I originally thought diluted share price was taking Mkt Cap a.k.a Equity Value, divided by diluted shares outstanding, which is derived using the treasury stock method on ITM options? Wouldn't the cash received by the company be assumed to be used for share buybacks?
I disagree with the preceding answer. As far as the P&L is concerned, any form of stock should be treated as an operating expense, and reduce the DCF-derived EV. On the liabilities side, treatment depends on the nature of the grant. I would treat ESOPs as options in the fully diluted share count, I.e. factor in dilution if in the money. The ESOP cost needs to be added back to the FCFF (equivalent to the company raising cash through an equity issuance). In case of an RSU, the liability side would increase for “deferred compensation“, but I believe no adjustment to share count is required, as RSUs should be backed by existing stock held in treasury (or authorized capital, but this is not issued yet, and would only be raised when the right to receive is exercised, resulting in a passive side transaction, I.e., deferred goes down an equity goes up, in which case also the share count would dilute). Again, as deferred compensation goes up, this leads to a hypothetical cash inflow, I.e. another add-back to FCFF. It’s been a while since I dealt with phantom stock, but AFAIR, this is merely deferred comp tied to the stock performance, and will result in a cash payment instead of actual shares, so also add-back in cash flow statement. Hope this helps!
I'm the OP from the proceeding answer, I had a think but something about adding back equity issuance doesn't quite sit right with me, seems like double counting the effect from equity issuance (from ownership changes). Found this article from Damodaran
I think this is a good way to think of it:
"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."
More here: https://aswathdamodaran.blogspot.com/2014/02/stock-based-employee-compe….
tdlr: Damodaran says do nothing
Agree with you and the professor here, also some companies might try to give an explanation that SBC is optional and it isn’t part of base salary for their employees, but that’s still a wrong notion because employees will accept a lower base and cash comp only if equity is granted (popular in tech companies). So adding back SBC leads you to understate comp expenses outside of SBC
Thanks for the provided article. Had some questions to your earlier post, but pertaining to the article you shared from Damodaran, think he mentioned at the end (correct me if I am wrong), Equity Value = Market Cap + Options Value. Is the value of options calculated using something like the black scholes model?
And I was confused by one of his paragraphs:
"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."
Does he mean RSUs should be included in the total count for shares, but options (i.e. using treasury stock method) should not be factored into the total share count?
I don't think I can explain this concept any better than the source itself, see
. It's a bit rambly at the start, but I'd watch all of it to get the full background. SBC discussion 11:37 onwards. He answers your other question tooBut regarding the two questions - yes, Damodaran uses BS to value the options. If you took a finance class in asset pricing, you'll be familiar with it. In practice, to be quite honest, I don't know why BS is not used, it seems not only more accurate but also quite straightforward (just plug and play...). Damodaran also has a spreadsheet on valuing options (see explanation here): https://www.youtube.com/watch?v=-sGw4oLPTsM
And regarding the second, yes exactly, but Damodaran does not use TSM (when he discusses this, the argument for why not is quite compelling imo) so there is no increase in share count. Include all share types including RSUs.
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