adjusting-for-share-based-compensation-and-dilution — equity valuation models

Share-based compensation (SBC) is a real economic cost that many investors ignore in DCF models, leading to overvaluation of 15-30% for tech companies where SBC runs 10-20% of revenue. The practical antidote isn't complicated: treat SBC as an expense (because it is), then use the treasury stock method to calculate diluted shares for your per-share value.

Why SBC Matters for Valuation (The Hidden Expense Problem)

SBC represents compensation paid in equity rather than cash. Accounting rules add SBC back to operating cash flow (because no cash left the building), but this creates a valuation trap: the cost didn't disappear, it was transferred to existing shareholders through dilution.

The point is: when a company issues $50M in stock options to employees, existing shareholders' ownership percentage shrinks. That $50M has to come from somewhere, and it comes from you.

The magnitude problem in tech: Among large-cap software companies, SBC averages 15-18% of revenue (with some exceeding 25%). For a company trading at 10x revenue, ignoring SBC inflates your valuation by 1.5-2.5x revenue turns, which translates to 15-25% overvaluation.

Why this matters: if you add SBC back to free cash flow without adjusting shares outstanding, you're valuing the company as if employee compensation is free. It isn't.

The Treasury Stock Method (Calculating Diluted Shares)

The treasury stock method estimates how many additional shares will exist when in-the-money options are exercised. It assumes the company uses option exercise proceeds to buy back shares at the current market price.

The formula:

Dilutive shares = Options outstanding - (Options outstanding x Exercise price / Current stock price)

Simplified: Dilutive shares = Options x (1 - Exercise price / Stock price)

Example calculation:

Options outstanding: 10 million
Weighted average exercise price: $30
Current stock price: $100

Dilutive shares = 10M x (1 - $30/$100) = 10M x 0.70 = 7.0 million additional shares

The durable lesson: when the stock price rises, more options become dilutive (and each option creates more dilution). This creates a ceiling effect on per-share upside that basic share counts miss.

Diluted shares outstanding = Basic shares + Dilutive shares from options + RSU shares expected to vest

For RSUs (restricted stock units), the calculation is simpler: count all unvested RSUs expected to vest as future shares. Most companies disclose this in their 10-K footnotes under stock-based compensation.

Adding SBC Back vs. Treating as Real Expense (The Fork in the Road)

You have two valid approaches. Choose one and be consistent:

Approach 1: Deduct SBC from free cash flow

FCFF = EBIT(1-tax) + D&A - CapEx - Change in NWC - SBC

Then divide by basic shares outstanding when calculating per-share value.

Approach 2: Ignore SBC in cash flow, adjust share count

FCFF = EBIT(1-tax) + D&A - CapEx - Change in NWC (SBC added back per GAAP)

Then divide by fully diluted shares (including all dilutive securities).

The point is: both methods capture the same economic reality if applied correctly. The common error is adding SBC back (Approach 2's numerator) while using basic shares (Approach 1's denominator). That's double-counting in your favor.

Decision rule: Approach 1 is cleaner for most investors. Deduct SBC as an expense, use basic shares, and you're done.

The Enterprise Value to Equity Bridge (Where Options Create a Liability)

When bridging from enterprise value to equity value per share, in-the-money options represent a claim on equity. You must account for them:

Standard bridge:

Enterprise Value
Plus: Cash and equivalents
Less: Total debt
Less: Minority interests
Less: Value of in-the-money options outstanding
Equals: Equity Value

Value of options = (Current price - Exercise price) x Options outstanding

Example:

10 million options with $30 average exercise price
Current stock price: $100
Option value = ($100 - $30) x 10M = $700 million claim on equity

If you skip this step, you're giving away $700 million of equity value to option holders without reducing your per-share estimate. The test: does your bridge explicitly subtract option value? If not, you're overstating per-share value.

Worked Example: Tech Company with $50M SBC

Your situation: You're valuing CloudSoft Inc., a software company with the following characteristics:

Revenue: $400 million
SBC expense: $50 million (12.5% of revenue)
EBIT (GAAP, after SBC): $60 million
Tax rate: 25%
D&A: $20 million
CapEx: $15 million
Change in NWC: $5 million
Basic shares: 80 million
Options outstanding: 12 million at $25 weighted average exercise price
RSUs expected to vest: 3 million
Current stock price: $75
Cash: $150 million
Debt: $0

Step 1: Calculate FCFF (deducting SBC as expense)

Since GAAP EBIT already deducts SBC, start there:

FCFF = $60M x (1 - 0.25) + $20M - $15M - $5M FCFF = $45M + $20M - $15M - $5M = $45 million

(If your EBIT adds back SBC, subtract the $50M explicitly.)

Step 2: Calculate enterprise value

Using a 10% discount rate and 3% terminal growth (simplified single-stage):

Terminal value = $45M x 1.03 / (0.10 - 0.03) = $46.35M / 0.07 = $662 million Enterprise value (at terminal) = $662M (simplified for illustration)

Step 3: Calculate diluted shares

Options dilution = 12M x (1 - $25/$75) = 12M x 0.667 = 8.0 million shares RSU dilution = 3.0 million shares

Diluted shares = 80M + 8M + 3M = 91 million shares

Step 4: Bridge to equity value per share

Value of in-the-money options = ($75 - $25) x 12M = $600 million

Equity value = $662M + $150M cash - $0 debt - $600M option value = $212 million

Per-share value = $212M / 80M basic shares = $2.65 (treating options as liability)

Or: Per-share value = ($662M + $150M) / 91M diluted shares = $8.92 (treating dilution in denominator)

Why this matters: if you ignored SBC and options entirely, you'd get ($662M + $150M) / 80M = $10.15 per share, overstating value by 14-280% depending on your method.

Common Errors (And the Dollar Cost)

Error #1: Ignoring SBC entirely

You add SBC back to cash flow (following GAAP) but forget to dilute shares or subtract option value. For a company with 15% SBC/revenue at 8x revenue multiple, you've overstated equity value by 120% of the SBC amount (the multiple effect).

Error #2: Double-counting in your favor

You deduct SBC from cash flow AND use diluted shares. This penalizes the company twice for the same expense. Check your model: if SBC is subtracted from FCFF, use basic shares. If SBC is added back, use fully diluted shares.

Error #3: Using wrong share count for options

You include all outstanding options, not just in-the-money options. Out-of-the-money options (exercise price > current price) don't dilute at current prices. The treasury stock method automatically handles this, producing zero dilution for underwater options.

Implementation Checklist

Essential (prevents 80% of SBC errors)

Confirm whether your FCFF calculation includes or excludes SBC
Match share count to your SBC treatment (basic if deducted, diluted if not)
Find options outstanding and weighted average exercise price in 10-K footnotes
Calculate diluted shares using treasury stock method

High-impact (for tech company valuations)

Calculate SBC as percentage of revenue (>15% requires extra scrutiny)
Trend SBC/revenue over 3 years (rising ratio = growing dilution)
Compare SBC treatment to analyst consensus (identify methodology differences)

Optional (for precision)

Value options using Black-Scholes for more accurate liability estimate
Project future SBC based on headcount growth and grant size trends
Sensitivity test: what if SBC rises to 20% of revenue?

Next Steps

Pull up your largest tech holding's 10-K. Find the stock-based compensation footnote (usually in Note 12-15). Calculate: (1) SBC as a percentage of revenue, (2) diluted shares using treasury stock method, and (3) the dollar value of in-the-money options. If SBC exceeds 10% of revenue and your valuation model doesn't explicitly adjust for it, you may be overstating per-share value by 10-20% or more.

References:

Damodaran, A. (2024). Equity Valuation: Employee Options and Restricted Stock. NYU Stern Valuation Resources.

FASB ASC 718 (2024). Compensation - Stock Compensation. Financial Accounting Standards Board.

SEC Staff Accounting Bulletin Topic 14 (2023). Share-Based Payment. Securities and Exchange Commission.

Adjusting for Share-Based Compensation and Dilution