The Real Cost of Stock Based Compensation Expense

Stock Based Compensation (“SBC”) doesn’t matter for investors (and employees/employers) until it is ALL that matters. Post the uproar after the crash laid bare the brazen cost of granting stock options to employees, stock comp had to hit a company’s income statement and reduce net income. Common sense.

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As we can all agree: compensation expenses, including share based payments, are an operating expense. Despite the rule change, regulators inexplicably allowed these payments to be added back in the cash flow statement. This nonsense distorts financial statements’ ability to explain a firm’s actual profitability.

SBC Accounting: Employees Become Both Labor & A Source of Capital

Friends. This just is not that complicated. When a company issues stock to employees or the public it increases shares outstanding and dilutes earnings per share. Give the stock to the employee and the cash doesn’t show up on the balance sheet. Robbing Peter to pay Paul. In broad daylight.

As we are witnessing today, life’s bills like rent, food, and gas have increased more than any time in the last 41 years. Why does this matter even more for the stock of aggressive growth companies? As these glamour stocks have taken a beating and the cost of living increases, the compensation equation needs to change.

Growth companies can handle this one of three ways. First, they can “top off” employees with additional stock like DoorDash thus further diluting shareholders. Second, they can increase salaries like Shopify. Third, they can offer stock to the public and pay employees in cash. No matter what it means more dilution or less cash to fund operations.

In the run-up to the peak of the bubble, stock comp felt good. Until the stocks started going down and it felt awful. That is precisely where we are today. It tends to be a self-reinforcing spiral.

The chart below updates our original chart from May of 2021 showing:

  • The total market cap of stocks where over a third of their revenues are given to employees in the form of stock comp
  • See that crashing line lower? History suggests it is going to keep falling
  • That decline will not feel good for the employees or the owners of these stocks

Stocks that Abuse Use Large Amounts of Stock Based Comp Look Vulnerable

Stock Based Compensation Expense: Cash Flow Statement Manipulation Explained

If you are interested in learning more about how the treatment of stock based compensation is polluting reported cash flows and firm valuations, we hope this section provides you with ample resources.

The academic on our team laid the issue out in a peer reviewed piece, Stock Compensation Expense, Cash Flows and Inflated Valuations. Summarily: the aggressive use of SBC financing is systematically overstating free cash flows making multiples of companies that use it aggressively, misleading. Typically, academia can be dense and difficult. Our professor’s piece is the essence of clarity.

Not into reading peer reviewed academia? The following KCR work makes the issue painfully quick and clear:

We also highly recommend the triple play of Herb Greenberg’s outstanding Empire Financial piece Trouble in Tech Land – Stock-Based Comp Was Fun While it Lasted with Jamie Powell’s deeply insightful FT Alphaville piece The hidden leverage of stock-based compensation finishing with the thoughtful stock example of Phil Ordway, Elliot Turner and John Mihaljevic in the MOI Global S2E23: Why Executive Compensation Matters | How the Market Thinks podcast.

The incredible thing about this is there is nothing to debate. There is no controversy. It is simply a matter of when the issue comes to a head. We believe that time may be now.

Please find below a list of all the stocks that are giving away 33% or more of their revenues in stock issuance to pay their operating expenses. To us, this defies common sense and does not seem sustainable. As always, we appreciate your interest and welcome alternate views and feedback.

If you are looking for possible opportunities around growth at a reasonable price, please see our free write-ups on Mohawk Industries stock and Hillenbrand. Both of those pieces are free, explain our and give an example of how our quantamental process brings discipline and efficiency to our investment strategies.

Stocks That Grant Stock Based Compensation in Excess of 33 of Sales

  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.
The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra for anyone seeking out more information related to the topics above.



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