As an investor, we can learn a great deal about a company by analyzing its policy on Stock Based Compensation (SBC), including the incentives it provides, how much it costs, and how it is implemented – everything from issuing stock to buying back the stock.
The goal of SBC is to get a company’s executives — the CEO, CFO, all those in upper management, and ideally anyone who makes important decisions — to think like owners. This alignment of thinking is so the company will be managed to best serve its stockholders over the long term. If we want executives to think like owners, we should give them shares of the company and make them owners, so they hold each other accountable. So, we pay our executives partially in cash and the rest of their salary comes in the form of shares. This is a summary of Stock Based Compensation.
Note: sometimes SBC is referred to as ‘Share’ Based Compensation rather than ‘Stock’
Table of Contents
There are many compelling reasons to pay executives in shares instead of cash. First, shares are like money for the company. Just like governments can print as much money as they want, companies can (in most cases) create as many shares as they want … out of thin air. It ‘appears’ to be free of cost. Second, there are tax benefits. Take a look.
Example of SBC payout:
Let’s say that a company gives its CEO $1M in cash.
The $1M is obviously a cost for the company. So, it’s taken out of the company’s income before taxes are paid.
When the CEO is paid $1M in shares, the same logic applies.
Tax regulations are undoubtedly extraordinarily complex. Only a part of SBC may be tax-deductible, so the numbers may not add up exactly the same. But there are usually important tax benefits to SBC.
Options & Restricted Share Units
There are 2 forms of SBC: (i) Employee Stock Options and (ii) Restricted Share Units (RSUs).
RSU’s are what we’ve been discussing, the issuing of new shares and paying executives with them.
Employee Stock Options are a little more complicated. We don’t give employees shares directly. Instead, we give them the “right” to buy shares at a certain price at a certain time in the future. We won’t be discussing these much, but it also plays a role in SBC.
Additionally, there is the idea of “vesting.”
Example of Vesting
A CEO may be promised 1,000,000 shares as SBC, but might not get all of them at once, and could be required to earn them over time. This is an example of vesting.
If the 1 million promised shares vest evenly over 4 years, the CEO could earn 250K shares in Year 1, 250K shares in Year 2, 250K shares in Year 3, and so on, up to and including Year 4. Vesting is not necessarily automatic, and it may be contingent on meeting a variety of goals.
500K of the 1M shares may vest no matter what, but the other 500K may only vest if earnings per share (EPS) double over the next 4 years.
Elon Musk and Tesla Vesting
Elon Musk had one of the most ambitiously bold SBC packages with Tesla. He had several targets that were $50B larger than the previous. He would receive large sums of shares when he reached $100B, $150B, $200B and so on. He managed to hit even the $650B mark, which many thought was never possible.
Let’s move on.
As shareholders, it’s helpful to look at SBC from both a quantitative and a qualitative perspective.
Quantitatively, we want to know how much SBC is going to cost us in the long run through diluting our stake in the company. Just like when the Federal Reserve prints more money, the value of each dollar goes down because there are more dollars chasing the same goods and services. Similarly, when a company issues more shares for SBC, the value of each share also goes down. Fortunately, dilution is much easier to understand than inflation.
Qualitatively, we want to know how the company’s SBC plan affects the CEO’s and other employees’ incentives. These incentives should, ideally, correspond directly to the best interests of shareholders. After all, this is the intended purpose of SBC. Though, there may be some misalignment of incentives. SBC plans may encourage executives to take unnecessary risks with shareholder cash, keep more profits than necessary, or repurchase shares at inopportune times.
Quantitative Discussion of SBC
In the United States, companies have to deduct SBC from their reported earnings (see Income Statement). But does this expense reflect the actual price that shareholders have to pay for SBC? Maybe not.
This is where we resort to first principles.
Earnings per share is what matters to shareholders.
The real cost of SBC is not that it lowers the company’s earnings, but that it increases the number of shares outstanding.
Example of SBC:
Let’s say a company made $1B this year (not including SBC).
The company can earn 16% on all the money it puts in.
Since this is a good return, the company plans to put all of its profits back into the business every year for the next 20 years.
So, the company’s income will grow at a 16% rate over the next 20 years.
At the end of 20 years, the company will make about $19.46B.
This is not even taking into account SBC.
Let’s assume we dilute the shares at 2.5% each year with SBC. That is, for every 100 shares that are already in circulation, we make two more out of thin air and give them to company executives as pay every year for the next 20 years. So, the number of outstanding shares will grow by a factor of 1.025^20 = 1.64 over the next 20 years. And what about earnings per share?
They’ll grow by a factor of ~11.76%.
So, earnings grow by a factor of ~19.46 (from above) without SBC.
And even with a small (really, understated) 2.5% SBC, earnings per share only go up by a factor of ~11.76.
So, over the next 20 years, SBC will directly cause each share to lose about 38%, of its value and the outstanding shares increase 164%. I’d look at this like a 38% tax to its long-term shareholders.
So, what do companies do in this case? They buy back the shares.
They issue new shares and give them to executives as SBC, and then they turn around and buy back shares from the market and then retire (remove) those shares. So in the end there is a net change in total shares.
Then they can say, “This year, we gave shareholders billions of dollars back in the form of share buybacks.”
When this happens, you should be asking these 3 questions:
- How much did the business say it spent on SBC?
- How many shares did they say they bought back?
- Did the number of share go up or down?
Example of SBC with Microsoft
The company Microsoft (MSFT) is, in my opinion, one of the greatest companies of all time.
In their 10-K for 2022, they reported they had repurchased 95 million shares for $28B.
But from 2021 to 2022 the shares only decreased 55 million.
That’s because the remaining 40 million shares (95 million – 55 million) were given to executives as SBC in this year alone.
So, about 40M/95M, or 42.11%, of the shares they bought back were just used to make up for the shares SBC dilution, not to retire shares.
Since they spent $28B in cash to buy back shares, I’d say the real cost of SBC to shareholders in 2022 was 42.11% of $28B or $11.79B
So, how much SBC hit MSFT as an expense? ~$7.5B (see Cash Flow Statement above)
Where’s the remaining ($11.79B – $7.5B) = $4.29B? This is the true cost to the shareholders that isn’t included in their Financial Statements. The question you can then ask is, did the management team add this as intrinsic value to the business, or was it simply removed from shareholders pockets?
Qualitative Discussion of SBC
Don’t forget, there’s another aspect we need to look at – the qualitative costs of SBC.
Advocates of SBC argue that giving executives shares puts them in the same position as owners. However, these incentives might not be aligned with the shareholders that purchased shares. From a psychological approach, investors had to purchase their shares on the market and carry the risk of a downside. Whereas executives that were given shares don’t worry about the downside. Executives may be incentivized to prioritize short-term earnings at the expense of long-term success due to the asymmetric risk and reward. This is all related to the Stock Based Compensation package and incentives for short-term performance.
For example, it can cause a company to take on too much debt, make acquisitions and share buybacks that are too expensive, among other things; all so that the executive can reach specific metrics in order to unlock their SBC packages.
Also, SBC whose vesting depends on meeting EPS goals can encourage executives to keep earnings and reinvest them in low-return projects, even though owners might have been better off if those earnings were given to them as dividends. It plays its role in incentivizing employees and executive leadership within organizations, but it’s important to understand the consequences it may have on a company’s financials, especially over the long term, whether it be good or bad.
Conclusion
Stock-based compensation is a tool that companies use to motivate and reward employees and executives. By paying them with stock instead of cash, they can offer a potential upside that cash cannot match. When choosing to implement stock-based compensation companies should consider the tax implications, the dilutive effects on earnings per share, and the potential value added to shareholders. The plan should include the company’s needs and objectives in terms or growth but also return value to shareholders in the same way as the employees, and simply not to over incentivize executives.
I hope these concepts that I discussed provides you with further insight on how to better understand Stock Based Compensation. If you wish to learn more or have particular questions about SBC, please feel free to ask below.
Definitions
Restricted Share Units (RSUs) plans typically offer units to an employee (whose value is derived from the shares of the company) that cannot be sold until certain conditions are met over a period of time. RSU’s are effectively deferred employee bonuses.
Employee Stock Options is a financial instrument that gives its owner the right, but not the obligation, to purchase a given asset at an agreed-upon price and date. These are a type of equity compensation given by companies to some employees or executives that effectively amount to call options. These differ from listed equity options on stocks that trade in the market, as they are restricted to a particular corporation issuing them to their own employees.
Vesting is the process of earning an asset, like stock options or employer-matched contributions to your 401(k), over time. Companies often use vesting to encourage you to stay longer at the company. Unless your company allows early exercising, you can only exercise stock options that have vested.
Earnings Per Share (EPS) is the monetary value of earnings per outstanding share of common stock for a company. It is a key measure of corporate profitability and is commonly used to price stocks.
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