Stock-based compensation or employee stock options have become popular today. It is used to attract, motivate and retain employees. Therefore it is imperative to account for the impact of stock-based compensation or employee stock options when you value companies. So how do you deal with stock-based compensation in your valuation model? We address this question on this page.
Impact of Stock-Based Compensation on the Three Financial Statements
Stock-based compensation or employee stock options impact your DCF valuation model in multiple ways. The quantity and timing of stock-based compensation’s impact on the three financial statements depend on the terms of stock-based compensation. In general, we should see employee stock options hit the three financial statements as follows.
- First, Stock-based compensation or employee stock options dilute equity or ownership of existing shareholders. So whatever valuation you have arrived at is now spread over a larger pool of owners, reducing existing shareholders’ value.
- Second, stock-based compensation is also an expense that shows up in your income statement.
- Third, stock-based compensation also hits your cash flow statements. The impact on cash flows occurs when cash is paid at the exercise of the options. The quantity and timing of stock-based compensation’s impact on the three financial statements depend on the terms of stock-based compensation.
Types of Stock-Based Compensation
There are two kinds of stock-based compensation broadly. Your treatment in your DCF valuation is different for both of these.
- Restricted stock: These are stocks issued to employees that vest on a vesting schedule. Since restricted stock numbers are precise and hit the common equity, we do not need to adjust the DCF valuation.
- Employee stock options: On the other hand, employee stock options are not stocks but only stock options. Employee stock options give the employee the right to buy stocks (not an obligation) at a specific price on a specified schedule. Therefore, we need to account for stock-based compensation given as employee stock options.
Professor Aswath Damodharan’s Approach
Professor Aswath Damodharan has outlined his approach to adjusting your DCF valuation for stock-based compensation as follows.
- Stock-based compensation impact on cash flows must be accounted for by the reduced operating margins. In other words, stock-based compensation expenses reflected in the income statement are not added back despite it being a non-cash expense. Prof. Damodaran states that the company will likely continue to issue stock based compensation and that this expense must be acknowledged by reducing operating margins.
- Reduce the value of your equity by the value of the options outstanding. Stock options that have not been exercised are valued using the Black-Scholes formula. Therefore, to account for stock options that have not been exercised as yet, you will value the stock options outstanding and reduce the value of the equity arrived at using your DCF valuation. The equity value arrived at is divided by the number of shares outstanding (not including the options) to arrive at the share price.
You can watch Professor Aswath Damodaran’s detail it out in this video.
You can also see Professor Aswath Damodaran’s adjustments in his DCF valuation models here.
Significance of Stock-Based Compensation
How significantly does stock-based compensation impact your DCF valuation? This depends on a number of factors.
- The more options outstanding (as a percentage of shares outstanding), the larger the impact on valuation.
- In the money options have more impact on valuation than out of the money options. This depends on two other employee stock option factors – the exercise price and the strike price.
- Clearly, the deeper in the money options are the higher the more impact on valuation.
- Expected dividends also impact the value of the options and so the valuation.
- The current interest rate environment also impacts the DCF valuation as it impacts the value of the options outstanding.
- The longer the maturity of the options, the higher the impact on valuation.
Notice that the above factors are also the inputs of the Black-Scholes options valuation formula! This is because we reduce the equity value by the value of the employee stock options to account for the dilution impact of stock-based compensation.
Other Approaches to Valuing Equity Based Compensation
Not all analysts agree with Prof. Damodaran’s method of adjusting your DCF valuation for stock-based compensation. Everyone agrees that stock-based compensation is an expense that must be accounted for. But some feel that Prof. Damodharan is double counting the stock-based compensation expenses when he reduces the operating margin and reduces the value of equity. So some consider only the value of options and reduce the equity value by the value of options (ie they do not add back stock option expenses as it is a noncash expense)
Other Aspects to Consider
When valuing equity, we reduce the equity value by the value of stock options in the DCF model. Here are a few other aspects to consider.
- Probability of exercise: Not all options are exercised. An assumption should be made here. We can also look at the historical precedent to make this assumption.
- Tax shield: As companies get a tax shield due to the stock based compensation, we must also account for the tax shield when valuing the equity of the company.
FASB’s ASC 718, Compensation-Stock Compensation, provides the technical guidance on how accountants report equity-based compensation to employees. You can read more about ASC 718, Compensation-Stock Compensation and current updates here.