Many US technology companies use stock compensation to help align workers’ performance with shareholder interests. But stock-based compensation also creates accounting distortions that add risks to unwitting investors—especially as growth company valuations face increased scrutiny today.

Engineers and salespeople in public US technology firms receive a significant portion of their pay in the form of stock-based compensation (SBC) (Display). Company boards and management teams generally believe that this is a good way to link workers’ performance with shareholders’ interests. Employees seem to like it too, judging by reports that tech firms compete hotly for talent with promises of stock.

Does Noncash Mean “Not Important”?

Tech firms also favor SBC because it flatters company accounts. Investors typically exclude SBC expenses from their calculations of free cash flow on the grounds that this expense is noncash. Firms issue so-called pro forma results and guidance without SBC expense alongside the official presentation. After all, managements tend to do what investors encourage them to do.

Accounting standards require the expensing of SBC. This is because SBC permanently increases (that is, dilutes) the share count, lowering future per-share returns. Equity dilution is noncash only in the trivial sense that it happens directly to the investor through the share count rather than immediately through the cash-flow statement, and in the future rather than the present. But a permanent reduction of future dividends per share is economically significant whether one calls it noncash or not.

Why Care About Stock-Based Compensation?

The divergence between official accounting earnings and pro forma earnings is often extreme. In fact, many US technology firms are unprofitable under the prescribed accounting rules. As a result, shares that are already expensive compared to inflated free-cash-flow numbers are astronomically so when compared to the official measure of earnings (Display).