Stock Based Compensation (SBC) – MoneyDhan

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Why Stock Based Compensation (SBC)?

 

As investors, I think we can gain a lot of insight into companies by looking at their SBC policies what incentives they create, how much they cost, etc. The goal behind SBC is we want a company’s executives the CEO, upper management, ideally anyone making important decisions to think like owners. That way, they’ll run the company in a way that maximizes the long-term interests of the owners (us shareholders). The logic goes: if we want executives to think like owners, why not just give them shares of the company and make them owners? So that’s the idea. We pay executives only partly in cash. The rest of their salary is in the form of company shares. That’s SBC.

 

Advantages of SBC

First, shares are like the company’s own currency. Just as governments can print all the money they want, companies can (mostly) create all the shares they want out of thin air. It seemingly costs nothing.

There are tax advantages. Suppose a company pays its CEO $1M in cash. This $1M is clearly a cost to the company. And so, it is deducted from the company’s earnings before income taxes are paid.

Similar reasoning applies when the CEO is paid $1M worth of shares. Of course, tax laws are super complicated. Only a portion of SBC may be deductible for tax purposes so the numbers may not work out exactly the same. But there are usually important tax advantages to SBC.

 

Types of SBC

     Options: Options are instead of directly giving executives shares, we give them the right to buy shares at a particular price at a particular time in the future.

     Restricted Share Units (RSU’s): RSU is issuing new shares and paying executives with them.

 

Vesting

A CEO may be promised 1M shares as SBC. But he may not get all the shares right away. He may have to earn them over a period of time. That’s called vesting.

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For example, if the 1M promised shares vest uniformly over 4 years, the CEO will become eligible to get 250K shares in Year 1, another 250K shares in Year 2, and so on up to and including Year 4.

Vesting is flexible. It can be conditional on the executives achieving some performance targets. 500K of the 1M shares above may vest no matter what, but the other 500K may vest only if per-share earnings double over the next 4 years.

 

 

Quantitative and Qualitative

Quantitatively itis important to understand how much SBC is likely to cost us over the long run via dilution of our stake in the company. Dilution occurs when a company issues new stocks which result in a decrease in an existing stockholder’s ownership percentage of that company.

Just as each dollar becomes less valuable (via inflation, more money chasing the same goods/services) when the Fed prints money, each share becomes less valuable when a company issues new shares for SBC.

Qualitatively, we want to understand how the CEO’s and other employees’ incentives are shaped by the company’s SBC plan. Ideally, we want these incentives to be directly aligned with shareholder interests. After all, that was the whole purpose of SBC in the first place.

In practice, though, there may be some “misalignment” of incentives. For example, SBC plans may incentivize executives to take on more risks with shareholder capital, or retain more earnings than necessary, or carry out share buybacks at inopportune times.

 

Cost of SBC

In the US, companies are required to take a charge against reported earnings for SBC. But does this charge capture the real cost of SBC to shareholders? I’d say no.

In SBC per-share earnings is what counts for shareholders. The real cost of SBC is not that it reduces the numerator (the company’s earnings), but that it increases the denominator (the number of shares outstanding).

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Quantitative Cost

For example, suppose a company earned $1B this year not counting SBC.

Also, suppose the company can earn 15% on all invested capital. Since this is a good return, the company plans to reinvest all its earnings back into its own business every year for the next 20 years.

So, over the next 20 years, the company’s earnings will grow at a 15% clip. At the end of 20 years, the company’s annual earnings will be $1B*(1.15^20) = ~$16.37B. That’s without considering SBC.

Now, let’s say we dilute the company by 2% per year for SBC. That is, for every 100 shares outstanding, we create 2 shares out of thin air and distribute them to company executives as compensation every year for the next 20 years.

So, over the next 20 years, the number of shares outstanding will grow by a factor of 1.02^20 = ~1.49. And what of per-share earnings? They will grow by a factor of (1.15/1.02)^20 = ~11.01.

So, without SBC, earnings grow by a factor of ~16.

But even with a modest (understated, really) 2% SBC, per-share earnings only grow by a factor of ~11.

Thus, over the next 20 years, each share will lose about (5/16)’th, or ~31% of its value as a direct result of SBC.

I’d argue that this “~31% tax” is the real cost of SBC to long-term shareholders of the company. In this case, SBC will cause the number of shares outstanding to grow steadily over the next 20 years by a factor of ~1.49.

 

Qualitative Cost

Promotors of SBC like to argue that giving executives shares puts them in the same boat as owners. But this “alignment of incentives” may not be all that perfect.

Owners had to shell out actual cash to buy their shares in the market. The big upside, big downside. Executives were just given the shares as compensation. Big upside, somewhat muted downside. At the very least, there’s a big psychological difference between the two.

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This asymmetric risk/reward perception created by SBC can create incentives for executives to boost short-term earnings at the expense of long-term results. For example, it can lead to taking on too much debt, making over-priced acquisitions and share repurchases, etc.

Also, large stock grants whose vesting is conditional on meeting EPS targets can incentivize executives to retain and reinvest earnings in low-return projects even though owners may have been better served had those earnings been distributed as dividends.

 

Key Understanding

Many companies don’t like to report such increasing share counts. It depresses per-share earnings and may give shareholders the impression that SBC is out of control. So companies like to buy back shares.

With their left hand, they issue new shares and give them to executives as SBC. With their right hand, they buy back shares from the market and retire them. And then they say this year, we returned billions of dollars back to shareholders.

In such cases ask 3 Questions:

  1. What did the company say they spent on SBC?
  2. How many shares did they say they bought back?
  3. What was the actual reduction in shares outstanding?

 

 

 

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Money Dhan

Money Dhan

Sujith comes with 15 years of experience in the derivatives market along with Long term Wealth creation via Large-cap companies. His theory is: If risk-free Bank FD generates 100% in X years, the Stock market should provide that return in half the time.
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