Share-Based Compensation Expense is Non-Cash in Nature? Not Really! - 14 Nov 2008
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DW - this guy has an interesting blog. you should check it out.
Friday, November 14, 2008
Share-Based Compensation Expense is Non-Cash in Nature? Not Really!
http://theharrissolution.blogspot.com/2008/11/share-based-compensation-expense-is-non.html
A few years ago all companies were
required to recognize the estimated value of all stock options in the
financial statements, predominantly as an expense on the P&L. It
has been said many times that share-based compensation expense is
non-cash in nature (which also includes the estimated value of
restricted stock and other equity-based compensation instruments). In
fact, numerous companies when reporting quarterly results disclose a
pro-forma EPS figure, which excludes the impact of expenses relating to
equity-based compensation. In form, stock-based compensation
expense is non-cash in nature. This is why the operating section of the
cash flow statement typically contains significant add-backs for these
expenses. However, in substance, there is a very real cash
element to most companies’ stock-based compensation plans - through the
consistent (and many times significant) use of share repurchases. Although
there are likely many reasons behind various companies’ motivation for
engaging in material levels of stock repurchases, a key reason is
undoubtedly the desire to control the dilution from the issuance of
stock options and restricted stock (and other forms of equity-based
compensation).
I frequently encounter companies that
have repurchased material levels of stock in recent years, many times
in the billions of dollars range (recall these outflows are classified
as financing activities within the cash flow statement). When I dig
into the disclosures of a recent 10-K and 10-Q, these companies
typically quantify the actual number of shares repurchased for a given
period. When digging deeper into the filings, disclosures can typically
be found quantifying the number of shares issued for stock-based
compensation plans. Importantly,
many times I discover that the number of shares issued relating to
stock options and restricted stock represent a significant percentage
of the total number of shares repurchased during a time period. For
perspective, it’s not unusual for this percentage to range from 50% to
70%, and sometimes may even exceed 100%. This is where it gets
interesting!
In situations like this, I would argue
there is a certain “level” of cash being used for buybacks to control
the dilution from shares that were originally issued for stock options
and restricted stock (i.e. employee compensation - essentially an
operating activity). Accordingly, I believe it would be appropriate to
deduct from reported free cash flow at least some level of cash being
used for these purposes.
How to adjust free cash flow.
The adjustment to free cash flow for share buyback activity can be
estimated by taking total cash used for share repurchases during a time
period (I recommend using a three-year time period) and netting this
amount against total proceeds received from share-based compensation
plans (e.g. from the exercise of stock options). This net amount (used
for share repurchases) can then be multiplied by the percentage of (1)
shares issued for stock-based compensation plans to (2) total shares
repurchased during the time period. The resulting dollar figure should
then be divided by the number of years in the measured time period
(e.g. three years) to come up with an average annual adjustment to free
cash flow (for estimated cash being used for share-based compensation
plans). In my opinion, it’s more practical to use a three-year
“smoothing” average (for share buyback activity) due to the notable
timing differences between (1) when stock options or restricted stock
awards are granted vs. (2) when the actual shares are issued and/or
became dilutive vs. (3) when shares are ultimately bought back to
control dilution from these incentive programs.
If
the above recommended adjustments are made, free cash flow for many
companies may potentially be reduced by meaningful amounts. Another
way to think about this – if a company would eliminate the use of
share-based compensation completely and instead increase cash
compensation for employees – “as reported” free cash flow would
obviously be reduced. This is why stock-based compensation is not really non-cash in nature.
required to recognize the estimated value of all stock options in the
financial statements, predominantly as an expense on the P&L. It
has been said many times that share-based compensation expense is
non-cash in nature (which also includes the estimated value of
restricted stock and other equity-based compensation instruments). In
fact, numerous companies when reporting quarterly results disclose a
pro-forma EPS figure, which excludes the impact of expenses relating to
equity-based compensation. In form, stock-based compensation
expense is non-cash in nature. This is why the operating section of the
cash flow statement typically contains significant add-backs for these
expenses. However, in substance, there is a very real cash
element to most companies’ stock-based compensation plans - through the
consistent (and many times significant) use of share repurchases. Although
there are likely many reasons behind various companies’ motivation for
engaging in material levels of stock repurchases, a key reason is
undoubtedly the desire to control the dilution from the issuance of
stock options and restricted stock (and other forms of equity-based
compensation).
I frequently encounter companies that
have repurchased material levels of stock in recent years, many times
in the billions of dollars range (recall these outflows are classified
as financing activities within the cash flow statement). When I dig
into the disclosures of a recent 10-K and 10-Q, these companies
typically quantify the actual number of shares repurchased for a given
period. When digging deeper into the filings, disclosures can typically
be found quantifying the number of shares issued for stock-based
compensation plans. Importantly,
many times I discover that the number of shares issued relating to
stock options and restricted stock represent a significant percentage
of the total number of shares repurchased during a time period. For
perspective, it’s not unusual for this percentage to range from 50% to
70%, and sometimes may even exceed 100%. This is where it gets
interesting!
In situations like this, I would argue
there is a certain “level” of cash being used for buybacks to control
the dilution from shares that were originally issued for stock options
and restricted stock (i.e. employee compensation - essentially an
operating activity). Accordingly, I believe it would be appropriate to
deduct from reported free cash flow at least some level of cash being
used for these purposes.
How to adjust free cash flow.
The adjustment to free cash flow for share buyback activity can be
estimated by taking total cash used for share repurchases during a time
period (I recommend using a three-year time period) and netting this
amount against total proceeds received from share-based compensation
plans (e.g. from the exercise of stock options). This net amount (used
for share repurchases) can then be multiplied by the percentage of (1)
shares issued for stock-based compensation plans to (2) total shares
repurchased during the time period. The resulting dollar figure should
then be divided by the number of years in the measured time period
(e.g. three years) to come up with an average annual adjustment to free
cash flow (for estimated cash being used for share-based compensation
plans). In my opinion, it’s more practical to use a three-year
“smoothing” average (for share buyback activity) due to the notable
timing differences between (1) when stock options or restricted stock
awards are granted vs. (2) when the actual shares are issued and/or
became dilutive vs. (3) when shares are ultimately bought back to
control dilution from these incentive programs.
If
the above recommended adjustments are made, free cash flow for many
companies may potentially be reduced by meaningful amounts. Another
way to think about this – if a company would eliminate the use of
share-based compensation completely and instead increase cash
compensation for employees – “as reported” free cash flow would
obviously be reduced. This is why stock-based compensation is not really non-cash in nature.
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