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.
Stock based compensation in the DCF
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. Full article: http://aswathdamodaran.blogspot.com/2014/02/stock-based-employee-compensation-value.html
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.
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 (we have also included an Excel file with this exercise here):
- 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
Step 1. How practitioners deal with 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.
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
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.