Wall Street Prep Stock Based Compensation

[Tyler Bannowsky]

Oncethe 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:

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.

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:

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.

A: Stock options and restricted stock are a form of employee compensation and a transfer of value from the current equity owners to employees. Employees certainly prefer a salary of $50,000 + options over a salary of $50,000 with no stock options. It is thus clear that when companies issue stock based compensation, this transfer of value needs to be captured somehow but the question is how?

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:

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.

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.

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.

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:

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:

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.

Hi. In the case of when all employees forfeit their options before vesting, what happens to the Equity reserve that has been built up over time? Do we have to reverse this APIC balance? Or will it forever remain on the balance sheet?

At the end of the vesting period, when employees have exercised their rights and shares have been issued i.e. converted to ordinary shares, will there be a journal entry to transfer from Share based premium reserve to Issue capital

And, seemingly more and more technology companies are looking to attract top talent through stock options such as RSUs. The impact of SBC to the long term cash flow of a business may become increasingly important over time.

A company may very well have to burn significant cash flow in a given year to build a factory, for example. In the years to follow, there might be little in cash outlays for that plant. But from the income statement side, that cash outlay is spread as an expense over many years rather than just one.

And, many stock options which are granted/vested will be accounted for in (diluted) shares outstanding. Which is why there are basic shares outstanding and diluted shares outstanding formulas. We recognize those as used to calculate basic EPS and diluted EPS, respectively.

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.

Professor of Valuation Aswath Damodaran also teaches that this real cost to shareholders should be reflected in a valuation model. He believes that SBC should NOT be added to Net Income in order to reach FCFE.

Recall the Google and Oracle examples; one company had SBC expense as part of Cost of Revenues and the other as part of operating expenses. Since FCFF is generally calculated by starting with Operating Income and moving to NOPAT, the FCFF formula will account for SBC expense, all through Operating Income.

According Wall Street Prep, SBC expense in the cash flow statement represents stocks issued. It will be reflected (as potential dilution) in the future. Additionally, footnotes to the financials should disclose the number of shares that are granted, issued, vested or unvested.

Because some companies do massive stock buybacks, you might not see the impacts of the dilution of SBC expense to shares outstanding. The amount of stock bought back can be so much greater than that issued for employee bonuses.

Regardless of where stock based compensation expense comes out from, whether through an increase in diluted shares outstanding or through cash spent in financing activities to buyback those shares, those are real dilutions to shareholders. It represents real cash obligations that never make it back to the owners.

Typically, the main balance sheet section of a model will either have its own dedicated worksheet or it will be part of a larger worksheet containing other financial statements and schedules. Before we dive into individual line items, here are some balance sheet best practices.

Unlike working capital, PP&E and intangible assets are depreciated or amortized (with a few notable exceptions like land and goodwill). This creates a layer of complexity in the forecasting, as illustrated below:

Conceptually, a share buyback is essentially a dividend to remaining shareholders paid in the form of additional ownership of the company. In our example, the $100 million that the company wants to return to shareholders can actually be achieved one of two ways: via a cash dividend or equivalently via a $100m buyback. The per share increase to each shareholder (all else equal) should amount to exactly $100 million in aggregate value. One benefit with the share repurchase approach is that unlike a cash dividend, tax can usually be deferred paid by shareholders on the buyback.

From a modeling perspective, barring some management guidance or thesis on future buybacks, if a company has engaged in recurring buybacks historically (the amount of buybacks can be found on the historical cash flow statement), straight-lining the amount into the forecast period is usually reasonable.

Retained earnings is the link between the balance sheet and the income statement. In a 3-statement model, the net income will be referenced from the income statement. Meanwhile, barring a specific thesis on dividends, dividends will be forecast as a percentage of net income based on historical trends (keep the historical dividend payout ratio constant).

And in a separate schedule in the 10K you can see a full breakout of $1,427m in year-over-year changes in OCI (much like the income statement is a breakout of the year over year changes in retained earnings):

Forecasting OCI is fairly straightforward. Because the gains and losses that flow into this line item are difficult to predict, the safest bet is to assume no change year-over-year going forward (in other words, straight-line the last historical OCI balance on the balance sheet):

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