Free cash flow mirage
How share-based compensation masks the true profitability
Today, we are going to explore share-based compensation and why ignoring or not understanding how it flows through the financial statements can mislead investors and lead to poor investment decisions.
The short history of share-based compensation
Share-based compensation (SBC) has always been controversial. Before 2006, the FASB (Financial Accounting Standards Board) allowed companies to keep SBC off the income statement as an expense as long as stock options were granted “at the money.” Since the cost of compensating skilled employees did not impact net income, companies could lavishly use stock options with little effect on operating margins and net income.
Warren Buffett was probably the most vocal investor in the late 1990s, arguing that the use of stock options led to overstated earnings and should be expensed. In his 1997 shareholder letter he wrote:
When Berkshire acquires an option-issuing company, we promptly substitute a cash compensation plan having an economic value equivalent to that of the previous option plan. The acquiree’s true compensation cost is thereby brought out of the closet and charged, as it should be, against earnings.
In 2006, FASB implemented Statement 123R, mandating companies to expense the fair value of all share-based compensation over the relevant vesting period. This change immediately impacted the earnings of high-SBC companies, such as technology firms. Since 2006, as the “Silicon Valley model” has achieved repeated success, SBC as a percentage of revenue has grown significantly.
The mechanics of share-based compensation
SBC is expensed on the income statement as a non-cash expense (like depreciation), allocated to cost of goods sold, research and development, or administration, depending on which type of employee receives the grant. So, how does this work in terms of accounting?
There are two main forms of SBC: restricted stock and stock options.
Restricted stock accounting is straightforward. At the grant date, the number of shares granted multiplied by the current share price gives you the fair value of the SBC. This amount is then typically expensed linearly over the vesting period. So, on the grant date, there is no impact on the income statement, but during the vesting period, the amount flows from balance sheet entries into the income statement.
Stock options are a bit more complicated, as they are financial instruments that give the holder the right, but not the obligation, to buy shares at a predetermined exercise price. On the grant date, an option pricing model (such as Black-Scholes) is used to estimate the fair value of the options granted. This fair value is recognized on the balance sheet at the grant date and then expensed, like restricted stock, over the vesting period. Where stock options differ is that, when the employee exercises the options granted, it creates a financing item called option proceeds, equal to the number of options exercised multiplied by the exercise price.
Free cash flow illusions: Accounting rules and their impact
SBC is widely used by many companies, but at the sector level, it is especially prevalent in the information technology and communication services sectors (where Alphabet, Meta, Netflix, and Disney are classified). More mature and stable sectors, like consumer staples and utilities, have low levels of SBC compared to technology companies.
The main reason technology companies are heavy users of SBC is that the market for highly skilled technologists, whether in hardware engineering or software, is extremely competitive. For many venture capital-backed companies, the use of SBC transfers much of the financing risk to employees while preserving precious cash as the company scales.
Back in the late 1990s, everyone was obsessed with earnings per share (EPS) and the price-earnings ratio (P/E). Many investors are still focused on these two figures, even though they can lead investors down a blind alley. The 2006 accounting change to SBC does suppress accounting earnings and can result in high P/E multiples for companies that use a lot of SBC.
Many companies have discovered two things. After the Great Financial Crisis, the EV/EBITDA multiple, widely used in the private equity industry, became the “new P/E multiple.” As a result, many technology companies began reporting non-GAAP figures such as “adjusted EBITDA margin.” Charlie Munger was a fierce critic of adjusted figures. In the Q3 2025 shareholder letter, Reddit argues that by adding back SBC, the adjusted EBITDA appears much better, and the EV/EBITDA multiple looks less stretched. Since SBC is a non-cash expense, some believe it should be added back to provide a better proxy for cash flow generation. The problems with this line of thinking will be addressed in the final section.
The next evolution in Silicon Valley was recognizing that EV/EBITDA is a quick heuristic often used by less diligent individuals in the private equity industry. Increasingly, the focus shifted to free cash flow and free cash flow conversion because these represent the cash flows companies can use to pay down interest-bearing debt or return money to shareholders through buybacks or dividends.
By focusing on free cash flow, technology companies can now present their free cash flow statements without any “adjustments” that might prompt difficult questions. Looking at Reddit again, the free cash flow according to the cash flow statement for the first nine months of 2025 is $420.6 million ($424.1 million minus $3.5 million), which is essentially cash flow from operations less capital expenditures.
Many financial websites used by both professional and retail investors rely on these cash flow statement figures, so if an investor uses a screening tool based on free cash flow yield, this measure is what goes into the screener. We will discuss why this is a major mistake. SBC should not be added back, even though it is a non-cash expense.
If we take the conventional free cash flow figure from the cash flow statement over the past 12 months, Reddit generated $509.7 million in free cash flow. However, if we back out the SBC, free cash flow drops to $166.6 million. On an enterprise value basis, the free cash flow yield falls from 1.5% to 0.5%. That is a significant difference and can be a decisive variable for a growth investor.
The long-term shareholder cost: Dilution and economic reality
Conventional free cash flow figures and free cash flow yields are misleading, and for high-SBC companies, they mask the true underlying free cash flow available to shareholders. However, the effects are visible, they just do not appear in the cash flow statement. Reddit’s outstanding shares have grown steadily since its IPO due to SBC. This represents real dilution for existing shareholders and, therefore, a transfer of value from shareholders to key employees.
Many high-SBC companies have recognized this, so they use excess cash flow to buy back their own shares (as an anti-dilution measure), keeping the number of outstanding shares flat instead of rising. An astute reader will immediately notice that if the company does this to conceal dilution, then the so-called free cash flows were not truly “free to shareholders.” But aren’t buybacks a return of capital? If there were no dilution, then yes. But since the sequence is SBC → dilution → buybacks, the free cash flow is essentially used to repurchase shares granted to employees. Thus, we come full circle, the buyback amounts to cash flows used for employee compensation.
The accounting and cash flows of SBC simply take a detour, likely confusing or even “tricking” many investors along the way.
The bottom line is that SBC may be a non-cash expense, but it should be treated as cash compensation, because the total compensation (cash plus SBC) awarded to employees represents the market price for acquiring that talent.
If SBC is included as an operating expense, as it should be, then the free cash flow calculation becomes net operating profit after taxes (NOPAT) minus net investments. When investors use this calculation, many technology companies appear very different from a free cash flow perspective.
So, next time you use Bloomberg Terminal, Yahoo Finance, or any other financial system, be aware that the conventional free cash flow figures displayed are often incorrect.
Updated on 19 November 2025
There is one interesting caveat to SBC. If an investor invests in a high SBC company that still looks attractive given the high level of SBC, then there is potentially a significant free cash flow expansion potential in the company. Why?
Because as the company matures, the need for SBC compensation for highly skilled employees go down. As the business scales the key person risk in the business goes down as the business creates large internal operational and development systems. This reduces the bargaining power of the single employee over SBC. As the business scales, the SBC in percent of revenue declines and is often not offset by an equal increase in cash compensation. This leads to expansion of the operating margin (EBITA margin) and thus higher free cash flow conversion and potentially repricing of the stock price.
Photo by Raul Kozenevski on Unsplash
Great article as always Peter. SBC is an extremely important topic that is often overlooked by investors - especially in high-growing tech stocks.
On another note, I’m curious to hear your view on the current “circular” financing happening in AI. There seems to be various opinions out there on the potential implications this has.