Stock Based Compensation (SBC)

Stock Based Compensation: Accounting Journal Entries

There are two prevailing forms of stock based compensation:

1. Restricted Stock
2. Stock Options

GAAP accounting is slightly different for both. We’ll start with an example with restricted stock and then proceed to stock options.

Restricted Stock Example

• On January 1, 2018, Jones Motors issued 900,000 new shares of restricted stock to employees
• Jones Motors current share price is $10 per share
• Employees cannot sell their shares for a “service period” of 3 years
• Vesting occurs only if employees stay with the company for 2 years; otherwise the shares are forfeited

The restricted stock accounting journal entries are as follows:

January 1, 2018 – The grant date

¹The unearned compensation account is simply a contra-equity account to make the balance sheet balance. It will be reduced as the employees earn their awards.
²Calculated as [900,000 shares * $10 per share].

First, notice that nothing really happened. An equity account was created and was exactly offset by a contra-equity account. Also notice that there is no income statement impact and no stock based compensation expense has been recognized yet. It will only be recognized once it’s earned (i.e. vested). Also notice that the value of each share of restricted stock recognized by Jones Motors on its balance sheet is equal to its current share price.  That’s not the case with stock options as we’ll see shortly.

January 1, 2019 – After one year

The same thing will happen on January 1, 2020 and again one final time on January 1, 2021.

So that’s the basic accounting for restricted stock under GAAP. The key takeaways are:

1. Common stock and APIC is impacted immediately by the entire value at grant date but is offset by a contra-equity account, so there is no net impact.
2. The value recognized for each restricted share is the same as its current share price (for non-dividend paying stock).
3. Restricted stock is recognized on the income statement over the service period

Once the restricted stock is vested, the employees that own them can trade them and do whatever they want with them.  However, if an employee leaves prior to vesting, the stock based compensation expense is reversed via the income statement. In our example, had the employees left after 1 year, the restricted stock would be forfeited and the following journal entries would need to be made:

January 1, 2019 – Employees forfeit their restricted stock

We now turn to the accounting and journal entries for stock options, which are a bit more complicated.

Stock options example

• On January 1, 2018, Jones Motors issued 900,000 stock options to employees
• The exercise price of the options is $10 per share.
• Jones Motors current share price is $10 per share.
• The fair value of each stock option is determined by Jones Motors to be $5 using the Black-Scholes option pricing model.
• The stock options will vest over 3 years: 33% on January 1 of each over the next 3 years.

The stock options accounting journal entries are as follows:

January 1, 2018 – The grant date

Nothing happens at the grant date. Unlike restricted stock, there are no offsetting journal entries to equity at the grant date. The stock options do not impact the common stock and APIC balance at the grant date.

January 1, 2019 – After a year of vesting

¹Calculated as 300,000 shares * $5 per share. This is an expense recognized on the income statement. It reduces retained earnings.
²To balance the balance sheet, APIC for stock options increases

The same thing will happen on January 1, 2020 and again one final time on January 1, 2021. Now unlike restricted stock, once stock options vest, they still need to be exercised in order to become shares.  So assume the following:

• On January 2, 2021, the day after all the stock options vest, all option holders exercise their options
• Jones Motors share price on the exercise date (January 2, 2021) is $20 per share.

January 2, 2021 – Upon the exercise of options 

¹Calculated as 900,000 shares * $10 per share.
²Calculated as 900,000 shares * $5 per share. As options are exercised and become common stock, the APIC – Stock Options account is reversed and transferred into this Common Stock & APIC – Common Stock account below.

Notice that the net increase to equity on the balance sheet at the exercise date is simply the amount of option proceeds.  When building financial statement models, the fact that there is actually a transfer from the APIC – Stock Options account to the Common Stock & APIC – Common Stock account is ignored and only the net effect is modeled. Notice also that the market price of Jones Motors stock price is irrelevant in the journal entries.

So far, we have described the GAAP accounting treatment of stock based compensation.  In practice, many analysts actually ignore the stock based compensation expense entirely when calculating EPS  or when calculating EBITDA or when valuing companies . We discuss the wisdom of these approaches separately in those individual articles.

How to Model Stock Based Compensation

Treatment of SBC Expense on Financial Statements

Prior to 2006, FASB’s view on this issue was that companies can ignore recognizing issuing stock based compensation as an expense on the income statement as long as exercise price is at or above current share price (restricted stock and in the money options had to be recognized but at the money options became common partly because they could stay off the income statement).

This was controversial because it clearly violated the accrual concept of the income statement.  That’s because even if a Google employee received Google options that are exactly at the current share price, these options are still valuable because they have “potential” value (i.e. if Google’s share price rises, the options become valuable). Until 2006 FASB’s view on this was “that value is difficult to quantify, so companies are allowed to keep it off the income statement.”

However, starting in 2006, FASB changed their mind on this and essentially said “actually, you really should need to recognize an expense lust like cash compensation on the income statement. And you should do this by using an options pricing model to value the options.” Since 2006, there is now an incremental operating expense that captures. Current period GAAP net income is lower because of this expense. Learn more about the accounting for stock based compensation here.

Why Does Stock Based Compensation Belongs on the Income Statement?

The accounting treatment of stock based compensation is consistent with accrual accounting guidelines and makes complete sense if your goal is to put together an accrual-based income statement.

In short, imagine two technology companies, identical in every way, except one decided this year to start hiring better engineers. Instead of mid-tier engineers that both companies have attracted to date, one of the two companies decided to start hiring top-tier employees.

The plan for attracting and recruiting the higher caliber talent involved sweetening salaries with stock options to new comp packages. The company hopes that better engineers will improve their products and thus grow the company’s market share and competitive position in the future. You’re giving employees better wages now – even if it isn’t in cash and your accrual based net income should be lower as a result.

And yet still, analysts often exclude it when calculating earnings per share (EPS). Another trend has been to exclude it from EBITDA. The reason is often simply that analysts are lazily trying to make accrual profit measures a hybrid between pure accrual and cash flows.

Complexities in Valuation: SBC Expense

A more interesting issue is whether stock based compensation should be ignored when valuing companies. Analysts care about EPS because it gives a rough gauge of value.

Specifically, many analysts use price to earnings (PE ratios) to compare companies. The idea being two comparable companies should trade at similar PE ratios. If one of those companies is trading at a higher relative PE ratio it could either be because:

1. The high-PE company is legitimately more valuable (i.e. It’s future growth prospects and returns on capital are higher, its risk profile is lower, etc).
2. The high-PE company is relatively overvalued.

Getting back to our example, let’s assume that the market thought the benefits to future growth due to better engineers is exactly offset by the extra dilution required to achieve it. As a result the share price of the better-hire company didn’t change.

If the stock analyst uses GAAP net income for calculating EPS (i.e. doesn’t exclude SBC), a higher PE multiple will be observed for the better-hire company than the no-SBC company.

This reflects the fact that lower current income to shareholders due to dilution from stock based compensation is offset by future growth.  In other words, current earnings are lower, but they will grow a lot more than the higher earnings of the no-SBC company. On the other hand, excluding the SBC from net income would show identical PE ratios for both companies.

So which is better?

When comparing companies that generally have compensation patterns (similar amounts of SBC relative to cash compensation), excluding SBC is preferable because it will make it easier for analysts to see PE differences across comparable companies that are unrelated to SBC.

This also helps to eliminate the impact of a company’s accounting assumptions for how it calculates SBC on earnings. These are the main reasons analysts in the tech space ignore SBC when valuing companies.

On the other hand, when companies have significant differences in SBC (as is the scenario we posed), using GAAP EPS which includes SBC is preferable because it clarifies that lower current income is being valued more highly (via a high PE) for companies that invest in a better workforce.

How to Model Stock Based Compensation in DCF Model

In summary, most of the time analysts exclude (add back) SBC when calculating FCFs in a DCF and this is wrong.

Analysts will argue that this is appropriate because it’s a non-cash expense.

The problem is there is obviously a real cost—as we discussed earlier—in the form of dilution which is ignored when this approach is taken. Indeed, ignoring the cost entirely while accounting for all the incremental cash flows presumably from having a better workforce leads to overvaluation in the DCF.

Stock-Based Compensation in the DCF

A recent SeekingAlpha blog post questioned Amazon management’s definition of free cash flows (FCF) and criticized its application in DCF valuation.  The author’s thesis is that Amazon stock is overvalued because the definition of FCF that management uses – and that presumably is used by stock analysts to arrive at a valuation for Amazon via a DCF analysis – ignores significant costs to Amazon specifically related to stock based compensation (SBC), capital leases and working capital. Of these three potential distortions in the DCF, the SBC is the least understood when we run analyst training programs.

In the SeekingAlpha post, the author asserted that SBC represents a true cost to existing equity owners but is usually not fully reflected in the DCF.  This is correct. Investment bankers and stock analysts routinely add back the non-cash SBC expense to net income when forecasting FCFs so no cost is ever recognized in the DCF for future option and restricted stock grants.  This is quite problematic for companies that have significant SBC, because a company that issues SBC is diluting its existing owners. NYU Professor Aswath Damodaran argues that to fix this problem, analysts should not add back SBC expense to net income when calculating FCFs, and instead should treat it as if it were a cash expense:

“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… 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.”

Source: Damodaran

While this solution addresses the valuation impact of SBC to be issued in the future. What about restricted stock and options issued in the past that have yet to vest? Analysts generally do a bit better with this, including already-issued options and restricted stock in the share count used to calculate fair value per share in the DCF. However it should be noted that most analysts ignore unvested restricted stock and options as well as out-of-the-money options, leading to an overvaluation of fair value per share. Professor Damodaran advocates for different approach here as well:

“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).”

Putting it all together, let’s compare how analysts currently treat SBC and Damodaran’s suggested fixes:

WHEN CALCULATING FCF USED IN DCF

• What analysts usually do: Add back SBC
• Damodaran approach: Don’t add back SBC
• Bottom line: The problem with what analysts currently do is that they are systematically overvaluing businesses by ignoring this expense. Damodaran’s solution is to treat SBC expense as if it were a cash expense, arguing that unlike depreciation and other non cash expenses, SBC expense represents a clear economic cost to the equity owners.

WHEN CALCULATING EQUITY VALUE PER SHARE…

• What analysts usually do: Add the impact of already-issued dilutive securities to common shares.
  Options: In-the-$ vested options are included (using the treasury stock method). All other options are ignored.
  Restricted stock: Vested restricted stock is already included in common shares. Unvested restricted stock is sometimes ignored by analysis; sometimes included.
• Damodaran approach: Options: Calculate the value of options and reduce equity value by this amount. Do not add options to common shares. Restricted stock: Vested restricted stock is already included in common shares. Include all unvested restricted stock in the share count (can apply some discount for forfeitures, etc.).
• Bottom line: We don’t have as big a problem with the “wall Street” approach here. As long as unvested restricted stock is included, Wall Street’s approach is (usually) going to be fine.  There are definitely problems with completely ignoring unvested options as well as out of the $ options, but they pale in comparison to ignoring future SBC entirely.

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1. Stock-Based Compensation Exercise

How big of a problem is this, really?

When valuing companies without significant SBC doing it the “wrong” way is immaterial. But when SBC is significant, the overvaluing can be significant.

A simple example will illustrate: Imagine you are analyzing a company with the following facts:

• Current share price is $40
• 1 million shares of common stock (includes 0.1m vested restricted shares)
• 0.1m fully vested in-the-$ options with an exercise price of $4 per share
• An additional 0.05m unvested options with the same $4 exercise price
• All the options together have an intrinsic value of $3m
• 0.06m in unvested restricted stock
• Annual forecast SBC expense of $1m, in perpetuity (no growth)
• FCF = Earnings before interest after taxes (EBIAT) + D&A and noncash working capital adjustments – reinvestments = $5m in perpetuity (no growth)
• Adjusted FCF = FCF – stock based compensation expense = $5m – $1m = $4m
• WACC is 10%
• Company carries $5m in debt, $1m in cash

2. Expected Future Issuance of Dilutive Securities

Valuing company using FCF (The typical analyst approach):

• Enterprise value = $5m/10% = $50m.
• Equity value = $50m-$5m+$1m=$46m.

Valuing company using adjusted FCF (Damodaran’s approach):

• Enterprise value = ($5m-$1m)/10% = $40m.
• Equity value = $40m-$5m+$1m=$36m.

3. Pre-Existing SBC Expense Calculation

Now let’s turn to the issue of pre-existing SBC:

1. Most aggressive Street approach: Ignore the cost associated with SBC, only count actual shares, vested restricted shares and vested options:

• Diluted shares outstanding using the treasury stock method = 1m+ (0.1m – $0.4m/$40 per share) = 1.09m.
• Equity value = $50m-$5m+$1m=$46m.
• Equity value per share = $46m / 1.09m = $42.20
• Analysis: Notice that the impact of future dilution is completely missing.  It is not reflected in the numerator (since we are adding back SBC thereby pretending that the company bears no cost via eventual dilution from the issuance of SBC). It is also not reflected in the deenominator – as we are only considering dilution from dilutive securities that have already been issued. This is doubly aggressive – ignoring both dilution from future dilutive securities that the company will issue and by ignoring unvested restricted stock and options that have already been issued. This practice, which is quite common on the street, obviously leads to an overvaluation by ignoring the impact of dilutive securities.

2. Most conservative Street approach: Reflect the cost of SBC via SBC expense, count actual shares, all in-the-$ options and all restricted stock

• Diluted shares outstanding using the treasury stock method = 1m+ 0.06m + (0.15m – $0.6m/$40 per share) = 1.20m.
• Equity value = $40m-$5m+$1m=$36m.
• Equity value per share = $36m / 1.20m = $30.13
• Analysis: With this approach, the impact of future dilution is reflected in the numerator.  The approach has us reflecting the dilutive effect of future stock issuances, perhaps counter intuitively, as an expense that reduces cash flow.  It is counter intuitive because the ultimate effect will be in future increases in the denominator (the share count).  Nevertheless, there is an elegance in the simplicity of simply valuing the dilutive securities in an expense that reduces FCF and calling it a day.  And in comparison to the approach above, it is far superior simply because it actually reflects future dilution somewhere. With regards to dilution from already issued dilutive securities, this approach assumes all unvested dilutive securities – both options and restricted stock will eventually be vested and thus should be considered in the current dilutive share count. We prefer this approach because it is more likely aligned with the rest of the valuation’s forecasts for growth. In other words, if your model assumes the company will continue to grow, it is reasonable to assume the vast majority of unvested options will eventually vest. This is our preferred approach.

3. Damodaran’s approach: Reflect the cost of SBC via SBC expense and value of options via a reduction to equity value for option value , count only actual shares and restricted stock

• Equity value after removing value of options = $36m – $3m = $33m
• Diluted shares = 1m + 0.6m = 1.06m (ignore options in the denominator because you’re counting their value in the numerator)
• Equity value per share = $33m ÷ 1.06m = $31.13

The Bottom Line: Stock-Based Compensation

The difference between approach #2 and #3 is not so significant as most of the difference is attributable to the SBC add back issue. However, approach #1 is difficult to justify under any circumstance where companies regularly issue options and restricted stock.

When analysts follow approach #1 (quite common) in DCF models, that means that a typical DCF for, say, Amazon, whose stock based compensation packages enable it to attract top engineers will reflect all the benefits from having great employees but will not reflect the cost that comes in the form of inevitable and significant future dilution to current shareholders. This obviously leads to overvaluation of companies that issue a lot of SBC.  Treating SBC as essentially cash compensation (approach #2 or #3) is a simple elegant fix to get around this problem.