# Forecasting ‘sticky’ stock-based compensation

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.

Although many companies exclude stock-based compensation (SBC) from alternative performance metrics (non-IFRS or non-GAAP), we firmly believe that the grant of shares or share options to employees is just as much a compensation expense as paying cash salaries and bonuses. Claims of the expense not mattering because it is supposedly ‘non-cash’ or that the cost is ‘double-counted’, considering the dilution effect on earnings per share, are nonsense. To learn why, see our article Dot-com bubble accounting still going strong – Tesla

We think it is vital that SBC is included in forecast performance metrics used in analysis and valuation. Consequently, it is important that investors understand the drivers of the expense and can make realistic forecasts.

Right now, understanding SBC forecasts is of increased importance for investors considering the Covid-19 related effects on profitability and share prices. The volatility of equity markets will impact the value of shares and options held by employees, and changes in profitability will likely impact the value of future SBC grants. You would think that, for many companies, a lower share price and/or lower profitability (and consequently lower grants of stock-based compensation,) would likely reduce the SBC expense. The problem for investors is that this may not be the case; the relationship between share prices, bonus grants and the reported SBC expense can be complex and often not intuitive.

• Falling share price: A reduction in the stock price does not have any direct effect on the SBC expense for most companies, even though past grants of equity instruments to employees, including those that have not yet vested1Grant date is when an employee is allocated stock or options. Vesting date is the date from which the employee can exercise options or sell shares. However, the ability to benefit from this is often subject to the employee meeting certain conditions. The shares or options vest when those conditions are met. The vesting period is the time between the grant date and vesting date. , may be worth considerably less. The exception is where SBC schemes are ‘cash-settled’ and reported as a liability in the balance sheet. Unlike grants of equity instruments, liabilities to pay cash are remeasured to reflect changes in estimates of cash payments – in this case due to changes in the stock price.
• Falling profitability: A reduction in profitability is likely to lead to lower management and employee bonuses, of which stock-based compensation is a part. Bonus payments are generally regarded as a variable cost that can be cut in times of stress. This almost certainly applies to cash bonuses but the effect on SBC is more complex. Just because the amount of stock and options granted to employees may be cut does not mean that the SBC expense will fall to the same extent; in fact, it almost certainly will not.

The SBC expense reflects a complex process of measurement, allocation and adjustment that can produce some surprising results. This is primarily due to the value of stock or options granted to employees being allocated to profit and loss over the vesting period and not immediately recognised as an expense. Because the allocation of past grants of SBC that have not yet vested is largely unchanged from the prior period, the overall SBC expense remains ‘sticky’ and may be much less of a variable cost than you might think.

### Measuring what is granted

The starting point for determining the stock-based compensation expense is to measure the value of share and option awards at the grant date.

Valuing common equity issued to employees by listed companies is relatively straightforward. Valuing stock options is much trickier. First, an option pricing methodology needs to be used, which requires estimated inputs, particularly volatility. In addition, there can be so-called market-based vesting conditions. For example, if the options only vest if the stock price rises to a particular level then this must be taken into account in the valuation. Furthermore, the valuation of options should reflect the tendency of employees to exercise options earlier than would be optimal. These complications make the SBC expense inherently subjective. Unfortunately, unlike other estimates in financial reporting, it may not be ‘trued-up’, as we explain below.

A lower stock price doesn’t necessarily reduce the value of stock and options granted; the number of shares and options granted may be increased sufficiently to offset the falling stock price, leaving the value of grants unchanged. In addition, for options, changes in the volatility input could increase the value of each option, even if the share price has fallen.

One of the problems for investors is that the value of grants in the period is not directly disclosed. The number of each individual security issued and the value per share or option is disclosed, but, inconveniently, they are not multiplied together or added up.

##### Vesting and expected forfeit

While the value of stock and options granted to employees is important, it does not represent the true cost to the company. Although sometimes stock or options are granted with no conditions, often vesting conditions are attached. The most common is that an employee must remain in employment until the vesting date, although further conditions related to individual or company performance may also apply. For example, options might only vest if a certain increase in profit is achieved over that vesting period. An ambitious profit target would clearly reduce the number expected to vest.

The true grant date value of an SBC award, and the input to the process to determine the expense, is the expected forfeit rate multiplied by the total grant date value.

Unfortunately, limited disclosures in financial statements mean that generally we cannot calculate the grant date value after adjusting for expected forfeits. While the number of past grants that have been forfeited in the year is disclosed, the expected forfeit rate for current period grants is not. The historical observed forfeits may give some clue but, particularly for performance related schemes, this may be an unreliable indicator.

Below is a typical disclosure. The grant date value before expected forfeits is $99.5m, which is the number of instruments (restricted stock units in this case) granted of 28.9m multiplied by the grant date value per share of$3.44. There is no disclosure about expected forfeits, only the actual number of past grants forfeited during the year.

### Allocating the expense to profit and loss

If stock-based compensation vests immediately upon grant, then the value of the awards granted is immediately reported as an expense. However, if vesting depends on continued employment then the expense is recognised over the vesting period. The allocation is done separately for each grant to employees and would generally be a simple straight-line amortisation.

In some respects, the grant date value and subsequent amortisation of the expense is somewhat like the accounting for fixed assets. The grant date value is equivalent to the capital expenditure in the period and the SBC expense recognised in profit and loss is equivalent to fixed asset depreciation. However, there is one crucial difference which is that the cumulative unrecognised stock option expense (that will be reported as an expense in future periods) is not shown in the balance sheet. Under US GAAP it is disclosed but, unfortunately, for IFRS reporters, it is not.

### Adjusting the expense for subsequent changes

In financial reporting, most amounts that are based on estimates are corrected or ‘trued-up’ in subsequent periods, with the adjustments reflected in profit (or sometimes in OCI). For example, impairments of receivables, such as loans granted by banks, are initially based on expected defaults but are progressively adjusted until the actual loss is known.

For stock-based compensation two factors may be subject to truing-up: the number of shares or options that vest and their value. However, for the latter, the approach depends on the nature of the scheme and whether what is granted qualifies as ‘equity’ or not.

##### Adjusting for changes in expected vesting

For all stock-based compensation schemes the expense reflects changes in the number of shares or options that vest. If, for example, at the time of grant only 70% of awards were expected to vest then, initially, the allocated expense is based on this estimate. If in a subsequent period, expected vesting rises to, say, 80%, the expense recognised after this change is adjusted. The current period expense is the difference between the cumulative expense that should be recognised based on the updated expected forfeit rate, less that amount of expense already recognised in prior periods. Ultimately the total expense recognised for each award reflects how many shares or options actually vest.

Changes in expected vesting is a key driver of changes in the expense and can produce some odd results. For example, if vesting is much less than anticipated in previous years some of the past expense may need to be written back in the current period, resulting in a low or even negative charge.

Lower profitability in the current environment may well result in a gain from an increase in expected forfeit if vesting is based on satisfying performance targets. However, redundancies may have the opposite effect because this could result in a shortening of the vesting period with a consequential increase in the reported expense.

You will generally not find any disclosure that separates the effect of changes in estimates of expected vesting or the vesting period from the rest of the SBC expense.

##### Adjusting for changes in prices

The impact of changes in the share price on the SBC expense depends on whether the instruments granted are ‘equity-settled’ or ‘cash-settled’. The distinction between these can be complex, but essentially:

• Equity-settled means that the company issues shares or options that meet the definition of equity for financial reporting purposes. For options, this means that, when exercised, the employee pays a fixed amount of cash for a fixed number of shares. Most schemes are equity-settled.
• Cash-settled means that the instrument issued is a liability for financial reporting purposes. For options, this generally arises when the employee receives a cash payment equal to the difference between the stock price and the exercise price. Cash settled options are often called stock appreciation rights.

For equity settled schemes the grant date value per share or option is not subsequently adjusted for changes in their value. This is the same as the accounting for any equity instrument issued by a company.

Not adjusting for changes in prices means that when options expire worthless, and no gain is made by the employee, an expense is still reported in the income statement based on the grant date value. A consequence of this is that any initial bias in measurement is never trued up; whatever value is placed on equity-settled options when granted is the basis of the ultimate expense. If, for example, a company uses an artificially low volatility to measure grant date value, then the expense will be permanently understated.

The rationale for ignoring the subsequent value change of equity settled options is that the employees received compensation for employment services equal to the fair value of the options at the time of grant but then, as an investor in the business, suffer a subsequent capital loss on their investment. The former compensation cost is an expense, whereas the latter change in the value of their equity investment is not.

However, for cash settled options that are reported as liabilities, changes in value are recognised in profit and loss, such that the eventual expense equals the amount of cash paid to the employees. The grant date value is the present value of the probability-weighted expected payment, but this is progressively adjusted until the final cash payment is made to employees.

The difference between how price changes affect the equity-settled and cash-settled option expense can produce very different results. If the stock price rises then the equity settled expense does not directly change, although there could be an indirect impact if this affects the number of options expected to vest. However, for cash-settled schemes the impact can be significant, a stock price rise in this case would immediately produce a higher expense due to the increase in the liability to employees and the higher expected cash payment.

### Putting it all together

The process of measurement, allocation and adjustment is perhaps best summarised in a ‘roll-forward’ of the unrecognised expense. The table below illustrates this for the more common equity settled scheme.

You will not see such a comprehensive table in the financial statement footnotes. Under both IFRS and US GAAP the reported expense is disclosed, and the grant date value, while not separately disclosed, can be calculated. The unvested and not yet recognised amount is only given by US companies, and generally not by IFRS reporters.

### Forecasting the stock-based compensation expense

There are two things you need to focus on when forecasting SBC:

• The change in the value of new SBC grants and how this impacts the reported expense, after allowing for length of the vesting period.
• The impact of changes in the expected forfeit rate and, in the case of cash settled options, changes in the stock price.
##### Value of new grants

The value of new grants should be closely related to other employment expenses, especially bonuses, and can be forecast in a similar way. However, remember that in times of stress, SBC may not be cut by as much as cash bonuses, given its non-cash nature. In addition, watch out for stock-option repricing and reloads2Repricing means changing the exercise price, often with the objective of keeping options in-the-money and maintaining their value for employees. Reloads is where new options are granted, generally on more favourable terms. The additional value granted to employees due to repricing or reloads counts as an additional grant and is allocated as an expense. designed to compensate employees who have lost out due to a falling share price. There is some evidence that, at least for senior management, some companies may have even increased SBC grants in 20203.

The effect of a change in value of new awards on the reported expense depends on the allocation process. A longer vesting period means that any change in the value of new grants has a correspondingly lower impact on the expense. If, for example, new awards are issued half-way through the accounting period and the vesting period is 3 years, then only 1/6th of the change in the value of grants feeds through the reported expense. In this case 5/6th of the expense is the continued amortisation of past grants. This means that if, for example the value of new grants is cut by 50% then, assuming constant grants in prior periods, the expense will fall by only 1/6 x 50% = 8%. This is what we mean by SBC being a ‘sticky’ expense.

However, the calculation is complicated by past growth in grants. Even if grants in the next period are cut, past growth in grants that are yet to be fully expensed may result in an increase in the expense.

If, for example, the value of past SBC grants in the above illustration has historically been increasing by 8% then approximately 5/6 of the expense will continue to rise by 8% even though new grants have been cut by 50%. The weighted average of past growth and forecast growth in SBC grants, taking into account the vesting period and when during the year grants are awarded, is a good guide to the change in the expense. In our example 5/6 x 8% + 1/6 x -50% = -2%. For a more accurate answer see the model below.

##### Changes in expected vesting and prices

Changes in the expected forfeit rate, and hence the number of shares or options that vest, affects the current period expense. In part, this is due to a change in the value of current period grants expected to vest but, in addition, it is due to the catch-up adjustment related to past grants. The effect of this catch up is greater for longer vesting periods, considering that there is a greater amount of ‘unamortised’ grant date value subject to adjustment.

It is next to impossible to forecast or model changes in the forfeit rate. Fortunately, the catch-up adjustment effect is likely to have little predictive value and would not be something to include in longer-term projections for the purpose of, for example, DCF valuation.

For cash-settled schemes there is the added complication of the value of the outstanding awards being further remeasured for changes in the stock price. This produces a similar remeasurement effect that would have little predictive value. However, unlike the forfeit rate, where your ‘best estimate’ is likely to be zero change, the remeasurement caused by price changes should reflect the positive expected equity return.

The following model illustrates the impact of changes in the value of SBC grants and expected forfeit rate on the forecast expense . The model is simplified and does not fully replicate the actual calculations upon which the SBC expense is based. Nevertheless, it should provide a useful basis for forecasting. The model applies only to equity-settled schemes. For a cash settled scheme there would need to be a further catch-up adjustment related to changes in the stock price.

#### Interactive model – Forecasting the stock-based compensation expense

Prior year SBC grants: This is the value of SBC grants in the prior period before allowing for expected forfeits. Calculate this from financial statement disclosures by multiplying the number of shares or options granted in the period by the value per share or option. The model uses this to derive the implied prior year and forecast year SBC expense taking into account the effect of expected forfeits, growth rates and timing of grants during the year.

Growth in SBC awards: The historical and forecast expected growth in the value of SBC grants made each period. This applies to the value of SBC grants in the period; the model calculates the change in the recognised expense based on different assumed vesting periods.

Expected forfeit rate: The proportion of grants that are expected to lapse prior to vesting.

Grant timing: The average point (month) during the year when share or options grants are made. For example, enter 6 if grants on average take place mid-way through the year. If grants take place earlier in the year then the influence of current period grants on the forecast expense is greater.

Recognised expense and the change from the prior period: The model calculates the expense for the forecast period that is consistent with the inputs, model assumptions and the implied growth in the grants for the prior period. Comparing this growth with the input growth rate for the value of new awards indicates the ‘stickiness’ of the expense. This output is provided for different assumed vesting periods.

Disaggregation of the forecast period expense: The expense comprises the allocation during the period plus the effect of the catch up due to a change in the expected forfeit rate. The allocation is analysed to show the contribution of new grants to the current period expense. If the forfeit rate is forecast to remain unchanged then the catch-up adjustment is zero. Where the forfeit rate changes, the impact on profit and loss is higher for longer vesting periods. A reduced forfeit rate will result in a higher expense.

Reconciliation of unvested stock-based compensation: This is an illustration of what we believe would be a more useful disclosure for investors and that would provide more transparency regarding how the SBC expense is derived. This is based on an assumed 3-year vesting period for the scheme.

Single scheme with constant historical growth: The model is based on the assumption that the company has a single stock-based compensation scheme, with all prior year grants having the same characteristics. Past grants are assumed to have grown at a constant rate and to all have the same expected forfeit rate.

Changes in expected forfeit rate apply to all grants: For the forecast period the input change in forfeit rate is assumed to apply equally to all past grants (which produces the change in estimate effect) and also to the new grants.

Vesting date: Vesting is assumed to take place in full at the end of the vesting period. For some schemes vesting takes place in stages over the vesting period, thereby reducing the effective average vesting period.

## Investors need better financial statement disclosures

Part of the problem for investors is that, while stock-based compensation disclosures under both IFRS and US GAAP can, in some respects, be quite detailed, we think crucial information on the underlying drivers of the periodic expense is missing.

We would like to see companies provide disclosures that better explain the derivation of the reported expense. The illustrative reconciliation in the model above demonstrates the type of disclosure that investors need. While not yet required by accounting standards there is nothing that stops companies from providing such a table on a voluntary basis.

We also think that the reported SBC expense should be disaggregated to highlight the impact of changes to assumptions, as we have done in the model for changes to the estimated forfeit rate. This is even more important for cash-settled schemes where changes in the stock price can produce very volatile effects in profit and loss. Some companies use this volatility as a reason to exclude cash settled SBC from their alternative performance metrics. However, this removes the more relevant and persistent underlying expense, along with the more transitory remeasurement effect arising from the stock price change. Disaggregating the expense, rather than ignoring it in performance metrics, would be much more useful for investors.

Not only do we think that the composition of the SBC expense and the process by which it is determined should be more transparent, we also believe that it is important that investors have up to date measurement of the fair value of unvested SBC and, in the case of equity-settled options, the fair value of those that have already vested. Without this, enterprise value calculations are much more challenging, as we explain in our article ‘Enterprise value: Calculation and mis-calculation’.

## Insights for investors

• Stock-based compensation is an expense. Don’t ignore it, even if management suggest that you should.
• The SBC expense in profit and loss is the result of measuring the value granted, adjusting for changes in expected vesting and allocation over the vesting period.
• Equity-settled and cash-settled option schemes can produce very different numbers in profit and loss, even if the value of the options initially granted to employees is the same. Cash settled grants are remeasured for changes in the share price, whereas equity-settled grants are not.
• Remember that the SBC expense is sticky. Changes in the value of options granted will only gradually impact profit over the vesting period.
• Limited disclosures complicate forecasting the SBC expense. Estimate the value to be granted in the period and combine this with an estimate of the allocation of past grants, taking into account the allocation period.
• What matters most for equity valuation is the value of future grants and the current fair value of unvested shares and unexercised options.

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