Search Results for: stock-based compensation

Stock-based compensation: The cash flow question

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How equity-settled stock-based compensation should be reflected in free cash flow analysis remains the subject of ongoing debate. There are two distinct questions: whether an effective cash cost exists when no shares are repurchased to offset dilution, and whether that cost should be measured at grant date or vesting date.

Both questions have direct implications for free cash flow, DCF valuation and comparisons between companies with different repurchase policies. We have previously argued that an effective operating cash outflow should be recognised at grant date. In this article we address the arguments raised against that view.

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Stock-based compensation: Transparency, timing and EPS

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Stock-based compensation can be difficult. Two approaches to measurement, valuation uncertainty, frequent adjustments for changes in estimates (including sometimes the stock price), and a dilutive effect in addition to an expense, all contribute this being a topic many investors try their best to avoid.

Investors are not helped by inadequate stock-based compensation disclosures. Some companies go further than required by accounting standards, such as Swiss bank UBS, whose helpful additional analysis gives more transparency. However, this analysis raises interesting questions about the timing of the expense and the impact on diluted EPS.

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Effective tax rates and stock-based compensation

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Stock-based compensation can have a significant impact on the effective tax rate. For US companies the effect is driven to a large extent by changes in the stock price. In 2021 this reduced the effective tax rate for many companies; however, in 2022 you could well see the reverse.

We use Netflix to explain the effect of stock-based compensation on cash taxes and deferred tax adjustments. The accounting is complex and made even more challenging for investors by differences between IFRS and US GAAP. Unfortunately, neither US GAAP nor IFRS financial statements may fully reflect the underlying economics.

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Q&A: Stock-based compensation – is there double counting?

Assuming it is not cash paid, how do you treat number of shares in your DCF calculation? I would have thought that you can either:

  • Not adjust FCF for the stock-based compensation, but reflect in dilution of shares; or
  • Adjust for stock-based compensation in FCF but don’t include issued stock in number of shares.

Is that correct? I would have thought adjusting FCF and including dilution would be double counting.

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Forecasting ‘sticky’ stock-based compensation

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Stock-based compensation grants to employees in 2020 are likely to be affected by the changes to share prices and reduction in profitability currently being experienced by many companies. However, the impact on the related expense and on reported profit may not be what you might expect.

For most companies, stock-based compensation is a ‘sticky’ expense that is only indirectly or partially affected by current period changes. Limited disclosure in financial statements makes forecasting this expense a challenge. You should focus on the value of new grants, the vesting period and the effect of potential changes to assumptions. Our interactive model will help.

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Dot-com bubble accounting still going strong – Tesla

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Some 20 years ago the dot-com bubble was in full swing. A feature of many technology companies at the time, and arguably a factor contributing to the bubble, was not expensing the significant amounts of stock options granted to employees.

Today stock-based compensation is included in IFRS and GAAP profit measures. However, many companies still exclude this item from key performance metrics provided to investors. Surely it is time for this practice to stop? We use the alternative performance measures given by Tesla to illustrate.

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In search of free cash flow – Amazon

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Amazon provides investors with three alternative calculations of a free cash flow metric. For 2018 these range from $8.4bn to $19.4bn. In contrast our preferred approach gives a negative free cash flow of $3.4bn. What explains these material differences?

The disclosures by Amazon about its free cash flow measures are good and the calculations go further than many other companies. However, in our view important components are missing. We explain our additional adjustments in respect of leased assets and stock-based compensation.

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Non-cash transactions: Filling a free cash flow gap

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The IASB is developing proposals to improve disclosure of non-cash investing and financing transactions. A single tabular note would show these transactions alongside the equivalent cash flows reported in the cash flow statement.

We support the proposals. Non-cash transactions are, in effect, pairs of offsetting cash flows, and omitting them can materially distort free cash flow. The proposed disclosure would give investors the data needed to make adjustments we have long advocated, although the need for careful analysis, and potentially further adjustment, remains.

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AI Hyperscalers – Capital expenditure and free cash flow

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The rapid expansion of AI related infrastructure by the big-tech hyperscalers, and the effect this capital expenditure has on free cash flow, has been a recent focus for equity markets. But does the capital expenditure reported in financial statements provide a complete picture?

We explain how metrics commonly used by investors understate capital expenditure and overstate free cash flow. Only by ensuring that the effects of leasing and other ‘effective’ flows are fully reflected in free cash flow will this important measure be relevant for equity valuation.

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Equity analysis when accounting and economics diverge

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Analysis becomes more difficult for investors if financial statements fail to faithfully represent the underlying economics of a business. Sometimes this reflects the limitations of accounting; however, sometimes the accounting is simply misleading – for example, US GAAP accounting for loan losses.

The FASB has recently issued an amendment to US GAAP to correct an anomaly where an accounting loss is recognised when loans are acquired, even though no economic loss has occurred. We explain why accounting and economic reality can diverge, and how the US GAAP amendment will help investors.

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Residual income valuation: OCI and clean surplus accounting

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Considering the market’s focus on earnings, other comprehensive income (OCI) can be easily overlooked by investors. We think OCI is always important in equity analysis, but if you use a residual income approach to valuation the requirement for a ‘clean surplus’ in your model makes it vital to consider gains and losses reported outside profit and loss.

We explain clean surplus accounting and why residual income valuations only work if your forecast financial statements meet the clean surplus condition. One aspect of financial reporting where this may be particularly important is expected currency translation differences.

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Football player transfers highlight wider reporting issues

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In many transactions the amount payable may not be not known until sometime after the related asset, liability, income or expense is recognised in financial statements. In some cases, the accounting for this ‘variable consideration’ is clearly specified by IFRS. However, in others, including the purchase of fixed assets, companies may adopt different approaches.

Intangible assets arising from football player transfers are a good example of where companies can apply different accounting policies for variable consideration. We use the financial statements of Manchester United to explain the challenges for investors.

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The diluted EPS calculation is 50 years out of date

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It will soon be the 50th anniversary of the publication of the Black-Scholes model for option valuation. The fair value of options has since been incorporated into several aspects of financial reporting. However, in the case of diluted earnings per share, the accounting still pre-dates Black-Scholes.

The treasury stock method for calculating diluted earnings per share only considers the intrinsic value of written equity options, such as warrants and employee stock options. We explain why this is a problem and the further reasons why the full economic value dilution resulting from these securities is not reflected in financial statements.

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Do not use non-GAAP metrics in equity valuation

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A forecast of profit is used for both valuation multiples and as a starting point in deriving free cash flow for DCF valuations. But should you use a forecast of the reported IFRS or GAAP measure, or a forecast of the adjusted non-IFRS or non-GAAP alternative performance measure (APM) presented by management? 

We think equity valuations should be based on forecasts of reported IFRS or GAAP earnings (albeit with some adjustment related to intangible assets). Forecasts of management APMs can be useful for understanding trends in performance but using these in equity valuation is likely to introduce a structural bias.

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Analytical insights from DCF value analysis

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DCF based values can be analysed between a current operating value and the value created by short-term growth, medium-term investment, and long-term franchise factors. We provide an interactive value analysis model and explain how this can help in understanding and refining DCF valuations, particularly if combined with adjustments in respect of intangible investment.

DCF value analysis gives more insight than the common split between the present value of cash flows in an explicit forecast period and the present value of the ‘terminal value’ at the end of that period. We demonstrate the approach by analysing the enterprise value of UK retailers Tesco and Ocado.

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Non-GAAP is more than earnings before bad stuff

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Non-GAAP measures can be useful for investors, but they are also controversial. Some argue that certain non-GAAP adjustments are unacceptable and should not be permitted. This recently happened to US company MicroStrategy, where the SEC required it to amend the presentation of cryptocurrency gains and losses.

We do not agree with the SEC approach and believe MicroStrategy gives valid reasons for its cryptocurrency non-GAAP adjustment. We have less sympathy with other aspects of the company’s non-GAAP earnings calculation. However, we believe that the disaggregation that results from all non-GAAP disclosures generally benefits investors.

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DCF terminal values: Using the right exit multiple

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If a valuation multiple, such as EV/EBITDA, is used to calculate a DCF terminal value, the multiple should reflect expected business dynamics at the end of the explicit forecast period and not at the valuation date. This is best achieved by basing the exit multiple on forward-priced multiples for the selected group of comparable companies.

We explain and illustrate with an interactive model the use of forward-priced multiples in DCF. We also discuss the choice of multiple (including why EV/EBITDA may not be the best) and whether to apply the exit multiple to reported or adjusted profit.

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Convertible accounting: New US GAAP inflates earnings

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Changes to convertible bond accounting under US GAAP will mean higher reported debt but, paradoxically, a lower (and sometimes zero) interest expense. In our view, the resulting increase in earnings is artificial, fails to faithfully represent the cost of convertible financing and will not benefit investors.

The recent surge in convertible issuance, and the use of so-called convertible bond hedges, may have more to do with favourable accounting than favourable economics. We use the recent convertible issue by Twitter to illustrate the revised US GAAP and compare this with the more realistic approach under IFRS.

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Enterprise to equity bridge – more fair value required

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A largely cost-based measurement approach in financial reporting generally provides sufficient information about operating ‘flows’ to enable investors to apply enterprise value based DCF (or DCF proxy) valuation models. However, fair values are crucial for the ‘bridge’ from enterprise to equity value.

Fair values are available for many, but not all, of the assets, liabilities and equity claims that should be included in the enterprise to equity bridge. We explain the limitations of current financial reporting and where you may need to do further analysis.

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Disaggregation is key to understanding performance

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Limited disaggregation of income and expense items with different characteristics impairs investors’ ability to assess and forecast performance. Recent proposals by the IASB for a new disaggregation principle and related disclosures of ‘unusual’ items will help. However, in our view, they do not go far enough.

The IASB also proposes to include management alternative performance measures (non-GAAP or non-IFRS) within audited financial statements. We welcome this. Additional subtotals can be helpful if they are clearly described and what is omitted is clearly identified. What would also help is to ban the use of labels such as ‘underlying’, ‘core’ and ‘recurring’.

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Amazon free cash flow – an update

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Last year we published an article about the calculation of free cash flow and the alternative approaches used by Amazon. That original article is still very relevant; recent accounting changes have prompted us to publish an update.

New accounting rules effective in 2019 change and improve the data available to you when making the adjustments we advocate. We explain these changes, provide updated free cash flow measures for Amazon based upon their 2019 financial statements, and consider the relevance of maintenance and growth capex in the analysis of free cash flow.

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