Many investors are rightfully sceptical of executive share-based compensation, particularly in the US. But the debate is typically around the adjustments made to companies’ declared earnings or the very large payments that can result, rather than a view of the absolute level of dilution and how this should change over a company’s history.
For stable businesses, adjusting for share-based compensation is relatively simple: add back the share compensation cost to the declared adjusted earnings (as discussed in our earlier blog companies typically chose to exclude share based compensation from their adjusted earnings). The impact from dilution however, is a little bit more complicated and doesn’t result in the same headlines as the absolute value of the payments made, but this is a shame because the impact on a company’s fundamental valuation can be material. As such, investors often overlook it.
So how do we think about the dilution?
When a company is at an early stage of its evolution, when its future is uncertain and it needs to attract top-tier management away from a stable and probably lucrative existing role, offering a sizeable chunk of equity is an important tool to entice experienced hands into the business. This makes sense – getting the right management in place is one of the key influences on a start-up’s success or failure and sacrificing a percentage of equity to build the right team is a reasonable approach. Moreover, it helps preserve cash, one of the most valuable assets early in the life of a fast growing business, for reinvestment.
Dilution from share-based incentives is more acceptable for young, smaller businesses. For more mature businesses, the share count dilution (percentage of the company that is granted for incentives) should shrink because otherwise, as we show later, there is an excessive transfer of value from shareholders to management.
The following graph gives a sense of the valuation impact from sustained share count dilution. It shows the valuation discount to a company’s intrinsic value assuming a range of perpetual growth in Free Cash Flow (FCF) and share count dilution. Perpetual growth is a slightly extreme assumption but it highlights how material the impact can be if dilution is sustained. If a company grows its FCF at 6% per annum and ‘only’ dilutes its shareholders by 2% per annum, the effect on the valuation is a very chunky c.35% discount on the intrinsic value (i.e., if there were no incentives), for 4% per annum dilution c.52% of the valuation is destroyed!
Two conclusions follow from this mathematical exercise. When investing into high growth businesses with heavy share-based compensation incentives, investors must check:
- Is this an inherently profitable and growing business – can it grow out of these incentives?
- Is there a clear intention to bring down dilution as the business matures?
Two case studies
A good example of value creation through issuing stock is Palo Alto Networks. In a recent note on the subject Bernstein[i] highlighted Palo Alto Networks in 2012 recruited their new, highly regarded CEO, Mark McLaughlin, from Verisign (where he was on $5 million per annum) by offering him 2% of the equity worth $10 million. This proved to be a great deal for both parties. The company has subsequently successfully floated and multiplied in value many times over. Mark has contributed materially to this success and 2% of the company is now worth $290 million. Giving up a chunk of equity proved in this case to be an excellent decision by shareholders. By July 2016, the business was, pre-stock compensation, profitable (c.40% FCF margins), generating c.$585m in free cash and is expected to grow at around 30%+ per annum for several years to come. With such a trajectory in financials, the business could grow out of its stock compensation expense (c.$407m).
However, the share count dilution remains at relatively high levels (FY14 dilution 8.2%, FY15 9.8%, FY16 6.7%). Beyond this point, to believe in long-term value creation for shareholders, the level of dilution must come down over the years. If it doesn’t, that level of dilution on an ongoing basis reflects a pretty significant hit to value for investors (40%+, depending on FCF growth assumptions, see chart above).
An example of not-so-good practice is Twitter. The share count dilution in 2014 was c.13% and in 2015 was c.8%, when the business was not generating cash (FCF) even before adjusting for stock compensation. Even before revenue growth began to stall, the business was neither profitable nor competitively well placed. It has been struggling to grow its user base and monetise it. One way out here for shareholders is a strategic acquisition by a larger player. Barring that, this is a business where stock compensation needs to be adjusted to the new economic reality since it appears very unlikely to be able to grow its way out of its predicament. This is not an easy road as rebasing stock compensation is likely to be accompanied by employee attrition.
The debate around share-based compensation has largely to date been around the impact on profitability or the headline grabbing value of the grants. Both are important. However a third area, the current and prospective levels of dilution, is just as important and for investors, is a vital part of the assessment of every company.
[i] Weekend Tech Byte: The Psychoanalysis of Stock-Based Compensation, Bernstein, 26 August 2016
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.