Lesson 5 of 8
Stock pay and dilution
Stock-based pay is a real cost even though it uses no cash. Track ten years of shares issued against shares bought back to see who actually gained.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Stock-based pay costs shareholders in new shares, and it is a real cost even though no cash leaves the company.
- A buyback and a stock-pay program can run at the same time, so the share count can rise while a company announces it is buying back stock.
- The number that shows what shareholders actually kept is shares issued minus shares bought back, not either one on its own.
Stock-based pay costs current owners a share of the company, paid to employees instead of to them. Whether a buyback offsets that cost is a question about two share counts, issued and retired, not about the buyback announcement alone.
Ten years of shares issued against shares bought back
- Shares issued, cumulative
- Shares bought back, cumulative
- Net shares added
Show the numbers
| Shares issued, cumulative | Shares bought back, cumulative | Net shares added | |
|---|---|---|---|
| Start | 0 | 0 | 0 |
| Y1 | 3 | 2 | 1 |
| Y2 | 6 | 4 | 2 |
| Y3 | 9 | 6 | 3 |
| Y4 | 12 | 8 | 4 |
| Y5 | 15 | 10 | 5 |
| Y6 | 18 | 12 | 6 |
| Y7 | 21 | 14 | 7 |
| Y8 | 24 | 16 | 8 |
| Y9 | 27 | 18 | 9 |
| Y10 | 30 | 20 | 10 |
A real cost, paid in shares instead of cash
Under ASC 718, Compensation, Stock Compensation, a grant of stock or options to an employee is recorded as an expense at its fair value on the grant date. The expense is spread over the period the employee has to stay to keep it. The cash flow statement then adds that expense back, because no cash left the company. That add-back is where the cost quietly disappears from a reader's view of free cash flow, unless it is tracked separately. Net-share settlement withholds some shares to cover the employee's tax, so a small amount of cash does leave the company for that portion. The expense is real. Had the company paid the same amount in cash and used it to buy shares in the open market for the employee, nobody would call that costless. Count it once: subtract the pay from free cash flow, or value the growing share count, not both.
Why the share count is the number to track
A company's own commentary usually describes the buyback, in dollars authorized or shares retired, and rarely describes the shares issued to employees in the same period with equal prominence. Both appear in the statement of stockholders' equity and in the diluted share count reported each quarter. Shares issued for acquisitions or sold for cash move that count too, not only employee grants. Reading the ten-year trend in that one number, diluted shares outstanding, nets all these flows automatically: a rising count means the company issued more than it retired, whatever the buyback announcements said.
What the buyback was actually for
A buyback that only offsets stock-pay dilution is not returning cash to existing owners. It is holding the share count roughly level while employees are paid in equity. A repurchase that shrinks the share count below where it started is a different, stronger action than one that merely slows its rise. A company that describes a buyback in dollars spent, without ever stating the resulting change in shares outstanding, is describing only the smaller half of the same picture.
Check yourself
A company records $50 million of stock-based compensation expense. How much cash left the company for it?
- None
- $50 million
- Half of it, $25 million
Show the answer
Answer: A.
Stock-based pay is settled in shares, not cash, so the cash flow statement adds the expense back, apart from any tax paid on employees' behalf. The cost is still real; it is paid mostly in shares rather than cash.A company buys back 2 shares a year and issues 3 shares a year to employees. After ten years, what happened to the share count?
- It fell by 10 shares
- It rose by 10 shares
- It stayed the same
Show the answer
Answer: B.
Each year adds a net 1 share (3 issued minus 2 bought back). Over ten years that is 10 more shares, even while the company was buying stock back.Which single number nets stock-pay dilution against a buyback in one figure?
- The dollar amount authorized for the buyback
- The stock-based compensation expense on its own
- Diluted shares outstanding, tracked over several years
Show the answer
Answer: C.
Diluted shares outstanding already reflects both issuance and retirement, so its trend shows the net effect without adding the two flows separately.Sources
- ASC 718, Compensation, Stock Compensation.
- Faber, Shareholder Yield, 2013, on netting shares issued to management against buybacks.
- Berkshire Hathaway shareholder letter, 1992, on issuing shares only when as much value is received as given, and on stock options as compensation that belongs in earnings.
What this leaves out
- The chart and the worked example use round invented numbers so the arithmetic can be checked by hand.
- A rising share count is not automatically bad: shares issued at or above their value, to fund growth that earns more than it costs, can leave existing owners better off.
- This lesson does not value the stock-based pay itself against what an equivalent cash salary would have cost.
- Nothing here is advice about any security.