SBC Adjustment

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Share-based compensation has become an increasingly prominent expense for public companies, particularly in the technology sector.

Under GAAP accounting rules, share-based compensation must be recorded as an expense. The problem is that many companies report non-GAAP "adjusted" earnings figures that strip out this expense entirely.

Terry Smith, Chief Executive of Fundsmith, dedicated a section of his 2022 annual shareholder letter to explaining how companies hide this expense and why doing so leads investors to overpay for stocks.

Smith examined the 75 companies in the S&P Dow Jones Technology Select Sector Index and found that share-based compensation expense as a percentage of revenue grew from 2.2% in 2011 to 4.1% in 2021. This may not seem like much, but revenues for these companies nearly quintupled during the same period.

Of those 75 tech companies Smith examined, 45 remove share-based compensation from their non-GAAP earnings per share, operating income, or both. That amounts to ~$26B of expenses adjusted out in 2021 alone, averaging $600M per company.

Unsurprisingly, the companies with the largest stock compensation burdens are most likely to hide them. Every single company with share-based compensation exceeding 5% of revenue removes it from their non-GAAP measures.

Below, we'll explain the five justifications companies use to defend this practice, show how it distorts valuation and cash flow metrics, and demonstrate why it leads to poor capital allocation decisions.

Companies typically offer five justifications for removing share-based compensation from their adjusted figures. Smith dismantles each one:

1) It's a non-cash expense

This argument falls apart quickly:

Interestingly, many of the same companies that exclude share-based compensation also push investors to focus on EBITDA, which conveniently ignores D&A costs as well.

As long as accrual accounting remains the standard, arguing that non-cash means “not real” doesn't hold up. If you want to evaluate actual cash movements, that's what the cash flow statement is for.

2) The calculation uses assumptions

Stock option expenses are calculated using option pricing models, which require assumptions about risk-free interest rates and future share price volatility. Companies argue this makes the expense too subjective to include.

But plenty of income statement items depend on estimates and assumptions. Depreciation expense, for instance, relies on management's judgment about how long assets will last.

The presence of assumptions doesn't justify removing an expense from the books.

3) Share prices fluctuate and are outside management's control

This is true. But commodity prices also fluctuate outside management's control, and those affect input costs and hedge values that flow through the income statement.

Nobody suggests removing those impacts from financial metrics.

4) It results in double-counting

The argument here is that shares given to employees show up twice: once as an expense on the income statement and again in the diluted share count used for per-share calculations like EPS.

But this logic only applies to per-share metrics. It offers no justification for excluding share-based compensation from operating income or gross margin, which many companies also do.

Financial statements are interconnected by design. When a company increases cash expenses, it ends up with less cash or more debt on the balance sheet, which then affects interest expense or interest income on the income statement.

With share-based compensation, the expense hits the income statement, and the shares eventually affect the denominator in per-share calculations. That's not double-counting. That's just how accounting works.

5) Everybody else does it

Smith calls this the most common and perhaps the most troubling justification. The fact that competitors exclude share-based compensation doesn't make it correct.

If anything, companies that report GAAP earnings honestly may find themselves at a disadvantage when investors compare their multiples to peers using inflated non-GAAP figures.

Smith illustrates the distortion with a comparison between Microsoft (MSFT) and Intuit (INTU).

Microsoft shares were valued at ~25x the consensus EPS estimate for FY2023. Intuit traded at 28.4x its non-GAAP consensus estimate for FY2023. Many investors might accept Intuit trading at a higher multiple given expectations of greater growth.

However, Intuit removes share-based compensation from its non-GAAP EPS while Microsoft does not.

Intuit's GAAP EPS guidance for FY2023 was $6.92-$7.22, while its non-GAAP guidance was $13.59-$13.89. The consensus estimate sat at $13.69, meaning most sell-side analysts accepted Intuit's non-GAAP adjustments, which excluded ~$1.5B of share-based compensation.

Smith calculates what Intuit's EPS would look like if the company expensed SBC the way Microsoft does.

The math requires an after-tax adjustment because SBC reduces taxable income. When a company records SBC as an expense, it lowers pre-tax earnings, which means it also pays less in taxes. The actual impact on net income is therefore SBC × (1 - tax rate), not the full SBC amount.

Using Intuit's TTM data as of January 2023:

Then if we compare the P/E multiples (we're using Smith's figures directly, which don't differ materially from our calculated values):

A 13.6% premium for Intuit over Microsoft might seem reasonable. A 72% premium on a comparable basis requires far more justification.

The problems extend beyond earnings metrics into cash flow analysis.

Under GAAP, share-based compensation gets added back to operating cash flow, which in turn feeds into free cash flow (FCF) calculations. This makes sense from a pure cash perspective since no cash leaves the company, but it distorts the picture of ongoing cash generation.

Some researchers argue share-based compensation should be reclassified from operating activities to financing activities. The decision to pay employees with shares rather than cash is fundamentally a financing decision, not an operating one.

Smith agrees with this view. A measure of operating cash flow that doesn't benefit from adding back share-based compensation more accurately reflects a company's ongoing cash generation.

Here’s the reclassification of Intuit’s cash flow statement:

After removing the $1.5B of share-based compensation from the $4.3B reported operating cash flow, the actual FCF yield drops from 3.4% to just 2.2%.

The most damaging effect may occur when management starts believing their own adjusted numbers and makes capital allocation decisions based on them.

Management teams often evaluate acquisitions by whether they're dilutive or accretive to EPS compared to the alternative of earning interest on cash.

During years of near-zero interest rates, almost any acquisition would appear accretive to EPS since the alternative was earning virtually nothing on cash.

When management relies on EPS accretion as the test for a “good deal” and also uses earnings adjusted to exclude share-based compensation, serious errors follow.

Smith points to Intuit's 2021 acquisition of Mailchimp for $12B, half in cash. The price represented 12x Mailchimp's revenues, not profits. As a result, Intuit's return on capital fell from 28% in 2020 to just 11% in 2022:

Yet on an adjusted EPS basis excluding share-based compensation, the deal likely wasn't dilutive. The Intuit CEO described the Mailchimp acquisition as “an absolute game changer.” Whether that's true in the way he intended remains to be seen.

Ultimately, the next time you see a company report “adjusted” earnings that exclude share-based compensation, remember what Smith and his team at Fundsmith call these figures: “fully deluded earnings per share.”