Stock-based compensation and dilution

Valuation and Accounting Q & AStock-based compensation and dilution
Harry asked 1 month ago

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

  • Do 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? As I woul’ve thought adjusting FCF and including dilution would be double counting.

1 Answers
Steve Cooper Staff answered 1 month ago

You are right that there is a danger of double counting, but this applies to only part of the potential dilutive effect.

There are two components to the dilution caused by stock options. First, the dilution attributable to options already outstanding but which have not yet been converted to ordinary shares and, second, the future dilution that will come from the issue of options in subsequent periods. It is the latter, not the former, where there is a danger of double counting.

If future option issuance is included as an effective cash flow in FCF (the solution we showed for the group exercise) then the options outstanding today can be dealt with by either …

1) Deducting the fair value of these options when converting your DCF enterprise value into an equity value and then dividing this equity value by the current basic (undiluted) share count; or

2) Not deducting the fair value of the options but instead dividing the DCF enterprise value less net debt by the diluted number of shares.

The problem with the second approach is that the diluted share count shown in financial statements (and used by data providers) is based on the so-called ‘treasury stock’ method which only takes into account the intrinsic value of share options. I don’t think this will give the correct answer. It is possible to modify the diluted share count to reflect the fair value but then you might as well do the first approach.

But then the problem with the first approach is identifying the current fair value of the stock options given that this is not disclosed in financial statements. This means that unless particularly significant you may well be better off just going for the simpler approach 2.

Regarding future dilution from future stock based compensation … This does not need to be taken into account as long as FCF is net of the value of option grants as we demonstrated. It would be possible to allow for this dilution and not put the option grants in FCF (and I have seen some models that do this, albeit I think incorrectly) however, it is difficult to get this right, particularly if the optionality is to be captured faithfully. The easiest approach is just the include the option grants in FCF.