Share-Based Compensation in Financial Statement Modeling and Valuation

Share-Based Compensation in Financial Statement Modeling and Valuation

Share-based compensation is usually integrated into operating expenses on the income statement based on an employee’s role. When forecasting operating expenses or margins, analysts often implicitly consider share-based compensation. If, for instance, Research & Development (R&D) expense, which includes a part of share-based compensation, is projected as a percentage of sales, then the analyst has indirectly forecasted share-based compensation. This indirect method generally works but may not be apt for companies in their infancy, as the share-based compensation percentage usually diminishes as companies mature. For such early-stage companies, a distinct share-based compensation model is suggested.

Additionally, for accurate free cash flow projections and balance sheet precision, forecasting share-based compensation distinctly is essential, especially for the statement of cash flows. This approach also aids in computing non-GAAP metrics, useful in comparative analyses and valuation. The typical method to forecast this expense is as a percentage of revenues. Using historical data, managerial guidance, or aligning with industry averages are among the strategies employed. In terms of financial statement integration, the counter-entry for share-based compensation is made to equity. If using the indirect method for cash flows, this expense is adjusted in the net income reconciliation on the statement of cash flows.

Forecasting Shares Outstanding with Share-Based Awards

For EPS forecasts, analysts have to project shares outstanding, with share-based compensation being a primary influencer. To model its effect, begin with forecasting the net share-based awards post-forfeitures, and predicting settlements of these awards in terms of common shares.

Predicting net awards usually utilizes historical growth rates available in note disclosures and should align with the forecasted share-based compensation expense. The same method can be used for forecasting settlements or, alternatively, one could assume that a portion of the outstanding awards will be settled each period. The basic shares outstanding can then be calculated by adding vested RSUs or exercised options and new issuances, and subtracting any share repurchases.

This can be expressed in the following formula: 

Basic Shares Outstanding at End of Period = Basic Shares Outstanding at Beginning of Period +RSUs Vested and/or Share Options Exercised + Share Issuances from Secondaries, Acquisitions, etc. – Share Repurchases

To determine diluted shares, one would add the count of dilutive securities to the basic shares. This can be tricky due to limited disclosures and the application of the treasury stock method. However, frequently, a portion of outstanding awards, based on historical data, is considered dilutive. Share options’ exercises affect cash flows, as cash is received from these exercises, but RSU vesting does not have a significant impact.

Diluted Shares = Basic Shares + Potentially Dilutive Securities (calculated using the treasury stock method)

Valuation Considerations with Share-Based Compensation

It is a misconception to disregard share-based compensation during valuation, as it is not a cash expense. Such compensation dilutes existing shareholders by transferring value from the company to its employees. A company cannot enhance its value just by substituting cash compensations with shares. Often, companies repurchase shares equivalent to the dilution from share-based compensation, causing it to behave like a cash expense.

In Discounted Cash Flow (DCF) models, share-based compensation is not included since it is non-cash. However, to account for dilution from unvested and future share-based awards, modifications are needed. For unvested awards, the dilution can be incorporated using diluted shares for per-share value computation in the valuation model. Some analysts, for a more conservative approach, might consider the sum of basic shares and potentially dilutive securities. To account for dilution from anticipated future awards in DCF valuation, it’s practical to deduct share-based compensation from free cash flow. Even if this is not technically correct, other methods like adjusting the equity value or increasing the share count should yield the same result.

Finally, in multiples-based valuations, if a non-GAAP measure like adjusted EBITDA or adjusted EPS, excluding share-based compensation, is used, it can inflate profits. What is crucial is the consistency in the metrics used for comparison. If comparing multiples across companies, sector averages, and industries, they should either all be GAAP-based or all be grounded in the same non-GAAP measure. Mixing the two is not advisable.

Practical Application in a Financial Statement Model

In financial modeling, accurately forecasting share-based compensation requires an examination of historical compensation patterns and a close reading of the company’s compensation policies. On the balance sheet, increased share-based compensation expenses translate to a rise in ‘additional paid-in capital’ in equity.

For valuations, especially within DCF models, it is critical to maintain a consistent approach to share-based compensation and to consider the company’s share repurchase strategy, which can mitigate dilution effects. In multiples-based valuation, ensure uniform use of either GAAP or non-GAAP metrics for comparability across companies.

Example: Techno Dynamics Inc. Share-Based Compensation Plan

Techno Dynamics Inc. (TDI), is a technology firm based in Germany, reporting under US GAAP. The company has disclosed the following information in a note to its financial statements titled “Share-Based Compensation”: TDI grants restricted stock units (RSUs) to its executives, employees, and directors of up to 50 million Class B ordinary shares. RSUs vest 30% on the second anniversary year from the grant date and the remaining 70% vest in 14 equal semi-annual installments. RSU activity for the two years ended 31 December 20X2 was as follows:

$$ \begin{array}{l|r|r}
\textbf{Description} & {\textbf{Number of} \\ \textbf{shares} } & {\textbf{Weighted} \\ \textbf{Average} \\ \textbf{Grant-Date} \\ \textbf{Fair Value} \\ \textbf{per Share} \\ \textbf{(EUR)}} \\ \hline
\text{Unvested at 31 December 20X0} & 3,000,000 & 15.00 \\ \hline
\text{Granted} & 4,000,000 & 25.00 \\ \hline
\text{Vested and settled} & (1,500,000) & 18.00 \\ \hline
\text{Forfeited} & (600,000) & 20.00 \\ \hline
\text{Unvested at 31 December 20X1} & 4,900,000 & 22.00 \\ \hline
\text{Granted} & 3,200,000 & 55.00 \\ \hline
\text{Vested and settled} & (2,000,000) & 23.50 \\ \hline
\text{Forfeited} & (300,000) & 30.00 \\ \hline
\text{Unvested at 31 December 20X2} & 5,800,000 & 40.00
\end{array} $$

Share-based compensation expense for RSUs is measured based on the fair value of the Company’s ordinary shares on the date of grant. TDI accounts for forfeitures as they occur. Unrecognized share-based compensation expense as of 31 December 20X0, 20X1, and 20X2 was EUR 45.6, EUR 110.4, and EUR 232.0 million, respectively.

Operating Expense Calculation

For 20X2, the operating expense recognized for the Equity Incentive Plan was calculated by taking the product of vested RSUs and their grant-date fair value and subtracting the product of forfeited RSUs and their grant-date fair value:

Vested RSUs: \(2,000,000 \times \text{EUR } 23.50 = \text{EUR }47,000,000\)

Forfeited RSUs: \(300,000 \times \text{EUR } 30.00 = \text{EUR } 9,000,000\)

Operating Expense for 20X2: \(\text{EUR } 47,000,000 – \text{EUR }9,000,000 = \text{EUR } 38,000,000\)

The basic shares outstanding increased by 2 million in 20X2, the number of RSUs settled.

Income Tax Impact

The impact on income tax expense related to share-based compensation in 20X2 was calculated using a statutory tax rate of 15%. With an average market price of EUR 60.00 at the time of settlement for RSUs that vested in 20X2, the tax impact was a reduction in income tax expense.

Tax Benefit: \(0.15 \times [(\text{EUR }60.00 \times 2,000,000) – (\text{EUR } 23.50 \times 2,000,000)] = \text{EUR } 10,950,000\)

Reduction in Income Tax Expense: EUR 10.95 million

Comparing TDI’s Tax Rate: IFRS vs. GAAP

Under IFRS, it is possible that TDI’s effective tax rate would be higher compared to that under US GAAP. The rationale for this difference stems from the treatment of excess tax benefits or tax windfalls from share-based compensation. In IFRS, these are recorded as gains in equity, whereas under US GAAP, they are accounted for as decreases in income tax expense on the profit and loss statement.

Diluted Shares Outstanding for the Year Ended 31 December 20X2

Assuming the following:

Basic shares outstanding: 200,000,000

Unvested RSUs: 5,800,000

Average share price: EUR 60.00

Diluted shares can be estimated using the treasury stock method. The unvested RSUs are added to basic shares outstanding, net of assumed repurchases which calculated based on the average unrecognized share-based compensation expense and average prevailing market price for the shares.

Average unrecognized Share-Based Compensation Expense is calculated as:

\(\frac{\text{EUR } 110.4 \text{ million} + \text{EUR } 232.0 \text{ million}}{2}=171.2\)

Dividing by the average share price of EUR 60.00,

$$ \text{Share repurchases} =\frac{171.2 \text{ million}}{60.00}= 2,853,333 $$

Diluted Shares outstanding are then computed as

Diluted shares outstanding \(= 200,000,000 + 5,800,000 – 2,853,333 = 202,946,667\)

If the weighted average share price during 20×2 was below the average share price of EUR 60.00, but with the same average unrecognized share-based compensation expense, more shares will be assumed to be repurchased, resulting in fewer shares added to the basic count in the diluted shares calculation.

Question

In the valuation of a company using a discounted cash flow (DCF) model, which adjustment is most likely needed to account for the effect of share-based compensation?

  1. Increase the projected capital expenditures to account for the future cash outflow.
  2. Deduct the share-based compensation expense from projected free cash flow.
  3. Adjust the discount rate to reflect the additional risk of dilution from share-based awards.

Solution

The correct answer is B:

When valuing a company using a DCF model, share-based compensation, despite being a non-cash expense, must be accounted for due to its dilutive effect on equity. The most straightforward approach is to deduct the share-based compensation expense from the projected free cash flows, thus reflecting the reduction in value attributable to current and potential shareholders.

A is incorrect: Increasing capital expenditures is not related to accounting for share-based compensation, as capital expenditures are cash outflows for long-term assets, not for compensating employees.

C is incorrect: The discount rate is used to account for the time value of money and risk, not specifically for share-based compensation. The risk of dilution is typically accounted for by adjusting the share count in the valuation model, not the discount rate.

Reading 12: Employment Compensation: Post-Employment and Share-Based

Los 12 (c) Explain how to forecast share-based compensation expense and shares outstanding in a financial statement model and their use in valuation

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