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.
The recognition of a stock-based compensation (SBC) expense has been required under both US GAAP and IFRS for over 20 years. The basic idea that the value of shares (and related instruments) granted to employees is an expense is now fairly well accepted1See our article ‘Dot-com bubble accounting still going strong’ for our explanation of why an expense exists and, additionally, why also reporting a diluted EPS is not double counting. and, at a high level, relatively straight forward to understand. At least we think it is well accepted by investors; for companies less so, as indicated by those that still exclude the expense from their non-GAAP metrics..
However, in our experience, investors still find that analysing and forecasting stock-based compensation is difficult. In part, this is due to the complexity of the accounting, in particular, the different measurement for equity and cash-settled instruments2The grant date value of equity settled instruments is not remeasured if the stock price changes. However, for instruments that are settled in cash and therefore classified as a liability, such as stock appreciation rights, the liability amount is updated for the effect of stock price changes, with the remeasurement an additional component of the overall SBC expense. and the adjustments required when expected vesting3The granting of shares and options is generally conditional on the employee remaining in employment for a certain period and sometimes also meeting certain performance targets. The grant date is when the instruments are issued, but potentially with conditions attached. Vesting date is the point when the grants become unconditional, and the employee is free to sell shares or exercise options. or the terms of grants change. However, in our view investors are not helped by inadequate disclosures, and the lack of linkage of the financial statement footnotes with the actual expense in the income statement.
Detailed disclosures about SBC awards are typically not linked to the expense
Generally, the stock-based compensation expense amount is shown alongside other employment costs in a note that provides additional disaggregation of this expense item. Further details about the nature of compensation plans, and the type, number and value of instruments issued to employees, is usually provided in a separate note. The problem is that these detailed, and sometimes extensive, disclosures do not help investors to understand the expense in profit and loss. There is generally no way to trace how the share-based compensation granted impacts the profit and loss expense in each period.
There are three additional things we think investors require to fully understand the SBC expense and which are lacking in most IFRS and US GAAP financial statements:
(1) Value granted in the period
While the stock-based compensation expense is based on the value of equity and options granted to employees, the amount recognised in each period is arrived at after applying an allocation process. The grant date value is recognised as an expense over the vesting period or, more accurately, the period the employees must provide services to become unconditionally entitled to the award. Therefore, only part of the expense recognised in the current period is due to grants made in respect of that period; the remainder represents an allocation of equity granted in prior periods. The problem for investors is that only the end result of the allocation process is presented; the underlying driver of this expense – the compensation granted each period – is not provided.
We think that the value of grants made in respect of a particular period is just as important as the allocated amount derived from current and prior periods that appears in the income statement. It is similar to the relationship between capital expenditure and depreciation of fixed assets, where both measures are relevant for equity analysis. Knowing what has been granted helps in forecasting the future expense and, in our view, is also the more relevant measure for current performance and for equity valuation.
(2) Adjustments for changes in estimates
Some shares and options granted will never vest due to conditions imposed on employees. These could be the condition of still being employed at the vesting date or a performance condition, such as the employee or company meeting certain targets. The SBC expense ultimately recognised reflects the actual number of shares or options that vest, not the number initially granted. This means that the expense is initially estimated based on expected vesting and then subsequently adjusted. The problem is that most companies do not disclose the impact of these adjustments or indeed the initial estimate of the number of instruments that are expected to vest.
Financial statements contain many estimates, the correction of which in subsequent periods produces catch-up gains and losses. Differentiating adjustments in respect of past transactions from the effects of new transactions is important when analysing current period performance. These adjustments are often separately disclosed, such as corrections of prior period tax provisions and assumption changes for insurance liabilities. Not showing the adjustments in respect of stock-based compensation is an added barrier to understanding and forecasting this expense.
(3) The effect of remeasuring the liability for stock appreciation rights
When options are cash settled (stock appreciation rights) and the employee has the right to receive cash compensation (albeit a payment based on the value of the company’s equity), the options are classified as a liability. While equity instruments are never remeasured after issue, liabilities are always remeasured to reflect the estimated and eventually actual cash paid on settlement. Initially, cash settled options are treated the same as all other stock-based compensation but in subsequent periods, not only is the expense progressively updated or ‘trued-up’ to allow for changes in the number expected to vest, but also for changes in the value of those instruments. The effect of these changes is not separately disclosed.
Value changes are disclosed separately from other components of the overall expense in many areas of financial reporting, such as the remeasurement of a pension liability. The value change for SBC is particularly unusual given that the liability is linked to the company’s stock price, where changes arguably result in a counterintuitive outcome. This is similar in some respects to the ‘own-credit’ gains and losses where financial liabilities are reported at fair value. In this case the fair value change is disaggregated to highlight the own-credit effect. We think a similar disaggregation of the cash-settled SBC expense to show the impact of the change in stock price would improve transparency.
UBS provides additional disclosures and more transparency
There is at least one IFRS reporting company, the Swiss banking group UBS, that provides welcome disclosures which go beyond the minimum requirements of IFRS 2. Their approach solves at least one of the issues we identify above.
The UBS accounting policy note is fairly standard but nicely explained. In it we highlight that each of the three issues we discuss above apply.
UBS stock-based compensation accounting policy note
UBS 2024 financial statements (highlighting added)
UBS grants equity to its employees as part of its annual bonuses. While the grants take place in February, they are based on employee and company performance in the preceding year. The reference above to the “period that the employee is required to provide service to be entitled to the award” therefore includes the year before grant. Awards in February 2025 will be partly recognised in the 2024 results and partly in the following 3 years to reflect their graduated 3-year vesting.
SBC is part of the variable element of employee costs (together with cash bonuses). Although the amount granted in respect of a given period may be fully variable like cash bonuses, the SBC expense reported in profit and loss is only partly so due to the allocation of prior period grants. This is something we highlighted in a previous Footnotes Analyst article ‘Forecasting ‘sticky’ stock-based compensation’ where we provided a model to illustrate how variable compensation is only semi-variable in financial statements.
The UBS note that we found particularly useful, and which goes beyond the requirements of IFRS 2, gives additional details about their variable compensation, including SBC.
UBS variable compensation note
UBS 2024 financial statements (highlighting added)
The second line ‘Deferred compensation awards’ shows the SBC expense (excluding that for financial advisors which is presented separately below). Notice that of the $1,250m expense, only $563m relates to awards made in respect of 2024, $687m is the allocation to 2024 of part of the award value granted in prior years. That same line also shows that $813m of the grants made in respect of 2024 is deferred to future periods. This means that the total value of the grants made in respect of 2024 (excluding those not expected to vest) is $1,376 ($563m + $813m). This differs from the recognised SBC expense for the year of $1,250m (again, for simplicity, excluding the financial advisors and ‘other’ compensation). The difference is actually not that material in 2024, but it has been more significant in other years.
Little or no information provided about expected vesting
This analysis is impossible for most companies due to the limited disclosures. Although under IFRS 2 the number granted in a given period and the grant date value per share is provided, there is generally no information about the percentage of grants that are expected to vest. It may be possible to derive an approximate average vesting percentage, but the result is generally unreliable.
UBS also provides the standard note that is required by IFRS 2 about the outstanding awards and the grants during the period.
UBS outstanding share-based compensation awards note
UBS 2024 financial statements (highlighting added)
According to this table, the value of awards granted in 2024 is $1,701m (65.4m x $26). The figures in the preceding table above are this amount adjusted to exclude the grants that are not expected to vest.
The UBS additional analysis is excellent, and we would wish all companies to provide it (and that it is mandated by IFRS 2). However, what is missing from the UBS footnotes is the effect of changes in estimates of vesting and the effect of the stock price change related remeasurement of their cash settled awards (although cash settled awards are small for UBS) – the second and third items in our list of missing disclosures above. We assume that the $687m in line 2 of the variable compensation note above includes the effect of these changes in measurement, but there is no disaggregation provided and no way to estimate how material these changes are.
Is allocation over the vesting period the right approach?
The above analysis raises the question of whether it is the IFRS 2 allocated expense amount, or the value granted in the period that is more relevant for equity analysis and valuation.
We have never been comfortable with the IFRS 2 (and US GAAP) deferral of part of the value of SBC granted in respect of a particular period. We think the service and performance conditions attached to awards do not in themselves justify a deferral and that most or all of the compensation is a reward for current or past employment services. Indeed, UBS seems to agree with us – or at least UBS did in 2003 when it submitted its comment letter to the IASB in respect of the exposure draft of the eventual IFRS 2. This is what they said …
Extract from the UBS comment letter on ED2 (the draft of IFRS 2)
UBS comment letter on ED2 share-based payments
In 2003, when this letter was written, both Dennis and Steve were working in UBS Investment Research. While we were separate from the group finance function, we knew those involved very well, in particular the then Head of Group Accounting Policy, who drafted the UBS letter. We shared the same view about allocating the SBC expense and said something very similar to the above in our own comment letter to the IASB on ED2.
The UBS Group letter is number 185 in this ZIP file which can be downloaded from the IASB archives. Our own UBS Warburg Investment Research comment letter is number 98 in this ZIP file.
At the time of these letters there was no SBC expense in financial statements. The lack of expensing was a big issue for investors during the period of the ‘dot-com’ bubble of the late 1990s through it its peak in March 2000. For more about the stock-based compensation debate, both then and now, see our article ‘Dot-com bubble accounting still going strong – Tesla’.
Value granted is more useful than the allocated amount reported in profit and loss
We think profit metrics would be more relevant for equity analysis and valuation if they reflected the value of equity granted to employees for the relevant period, with little or no allocation4We agree with the view in the UBS letter that some SBC grants should be deferred, such as retention awards for new employees. over the vesting period. This amount should be reduced to allow for those grants that are not expected to vest. Catch up adjustments would be included in the expense when expectations of vesting change, however, these would be less relevant for forecasts.
Unfortunately, given the disclosures available in financial statements, in most cases (with the notable exception of UBS) replacing the allocated SBC expense with the value of SBC granted in respect of that period is very difficult, and the result likely to be quite subjective. On balance, you are probably best advised to stick with the reported numbers, but be aware of the potential for this to be out of date and fail to reflect the current level of SBC grants.
Even if you are of the view that allocation of SBC grants over the vesting period is appropriate, we still think that the grant date value (adjusted for expected vesting) is important. It is forecasts of this amount that we think should be included in free cash flow for DCF valuation.
Impact of SBC expense recognition on diluted EPS
Whether the SBC expense is recognised in the period to which a grant relates, or is deferred and recognised over a longer period through to eventual vesting, also impacts diluted EPS.
The dilution calculation for written options uses the treasury stock method. The share count is increased to reflect the additional shares that would be issued if all options were exercised, but offset against this is the number of shares that could be repurchased using the option exercise proceeds.
For example, if 100 options are outstanding with an exercise price of 6 and the stock price is 10, an additional 40 shares are included in the diluted EPS calculation. This 40 comprises the 100 additional shares that would be issued less 60 shares that could be repurchased using the exercise proceeds (100 x 6 / 10). If the share price is less than the exercise price, the above would be negative but no dilution effect is reported (diluted EPS cannot be higher than the basic EPS). In effect, the diluted EPS reflects the intrinsic value of outstanding options5We think that the treasury stock method is flawed. Only reflecting the intrinsic value of options in diluted EPS does not fully capture the impact on ordinary shareholders of issuing these instruments. For more about this see our article ‘The diluted EPS calculation is 50 years out of date’..
Deferral of SBC reduces reported EPS dilution
The above applies to written options that are not SBC, such as share warrants. However, if the written options are issued to employees, there is an additional component to the calculation due to the deferral of the SBC expense. The amount of SBC expense that is deferred is added to the issue proceeds for the purpose of calculating how many shares could be repurchased under the treasury stock method. This idea is that employees must both provide future services to the value of the deferred SBC and additionally pay the exercise price to obtain the shares. The company will receive both these ‘payments’ and therefore should recognise both in the diluted EPS calculation.
In our above example, if the unrecognised stock-based compensation is 3 per option, the additional shares used for the diluted EPS is falls from 40 to 10 [100 – 100 x (6 + 3) / 10]. If the unrecognised compensation amount is 4 or more, there is no dilution effect reported.
We disagree with this approach. Even if SBC is deferred, we do not think including the deferral in the EPS calculation leads to a realistic measure of dilution. Indeed, most employee options are, in accounting terms, not dilutive at all at the time of initial grant, despite the obvious economic dilution that affects shareholders. If our preferred approach of immediate recognition were adopted, then automatically the diluted EPS would fully reflect the (intrinsic) value of the employee stock options.
As we advocated in our article ‘The diluted EPS calculation is 50 years out of date’, we think diluted EPS, as currently reported, does not provide investors with a realistic measure of the value dilution ordinary shareholders suffer where companies write call options. A better approach is to focus on enterprise value with the fair value of all outstanding options and other equity claims included in a market enterprise value and in the enterprise to equity bridge. Unfortunately, the balance sheet date fair value of equity settled SBC is not disclosed either. This also makes an enterprise value approach challenging, as we explain in out article ‘Enterprise to equity bridge – more fair value required’.
Insights for investors
- The stock-based compensation expense equals the value of equity and equity linked instruments granted to employees, adjusted to reflect only those expected to vest. The expense is recognised in profit and loss over the vesting period.
- Equity settled SBC is not remeasured for changes in the stock price. Cash settled stock appreciation rights are classified as a liability and are updated to reflect stock price changes and the expected cash payment, with ongoing adjustments also included in profit and loss.
- Most companies do not provide any disaggregation of the SBP expense to show the effects of deferred recognition, changes in estimates of vesting and changes to the liability for stock appreciation rights.
- We think the grant date value (adjusted for expected vesting), rather than the reported SBC expense, is a better measure for both evaluating performance and for DCF valuations.
- The diluted EPS calculation includes the unrecognised stock option expense as part of the issue proceeds in the treasury stock method. We think this understates the dilutive effect of employee stock-options.