Every week I’ll provide updates on the latest trends in cloud software companies. Follow along to stay up to date! Let’s Talk About SBC I need to put on all my body armor before jumping into a topic as controversial as SBC (stock based compensation)… It’s a bit of a longer post so bear with me. First let’s define it for those who aren’t familiar with SBC. At most (all?) cloud software businesses compensation comes in two parts. Salary (cash) and equity grants (SBC). SBC is generally expressed as a dollar value (eg “we’re granting you $400k worth of equity over 4 years), it vests (typically a 1 year cliff and then quarterly), and can be granted as options (there’s an exercise price) or as RSUs (no exercise price). It also generally represents a large portion of total comp! The exercise price represents the price at which employees can purchase shares. If the exercise price is $80 and the stock is trading at $100 employees can exercise (buy for $80) and then sell for $100 on the open market for a $20 / share profit. At the time of this exercise, 1 additional share enters into the public markets (dilution).
Thank you for the article Jamin, this is a topic I've been spending a lot of time thinking about myself. One change that I've begun to implement is running DCF's based on FCF per share vs. on just FCF basis. By running a DCF on FCF per share you incorporate the negative impact of SBC in the dilution projections. It's slightly different than looking at the intrinsic value of the business but rather the intrinsic value of the cash flows a shareholder has rights to on a YoY basis. Running a simple 10 year DCF per share calculation sensitivity, I've found that for every incremental point of dilution leads to a ~4% valuation impact for the Company (i.e. running a normal DCF for a Company might imply $100m valuation, but if you incorporate 2% of dilution a year the intrinsic value becomes $92m).
Let me know what you think if you think this approach makes sense or any glaring holes.
IMHO, the most important part of the weekly Clouded Judgment epistle is the "NTM Rev Growth vs NTM Rev Multiple" chart. The weekly changes in the chart are intriguing! The slope of the line changes each week, indicating a relative change in perceived valuation of the SaaS market. Can you provide a comparison between the SaaS chart results and an equivalent for the Nasdaq and others?
Could you please share a calculation example for this:?
Bottom-line from our analysis, for every additional percentage point of share dilution seen from SBC versus the industry average – 2.5% per year for 15-30% growers and 4% per year for 30%+ growers, we estimate EV/Sales multiples should be adjusted down by ~6%.”
Thanks for again addressing this very controversial issue of SBC. Can you link the article from Keith Weiss as I would like to study it further. Two comments from me:
1) You can argue that you don’t need to reduce FCF by the SBC but you are in effect doing just that when you follow Keith’s argument of reducing the valuation multiple. That effect would be exactly what would happen if you were doing a DCF since lowering FCF would have the impact of lowering intrinsic value and therefore the valuation multiple. So really, you ARE buying into the negative impact of SBC on FCF. I think that is exactly the proper way to think about this but certainly agree that teasing out its precise NEGATIVE impact on FCF is very tricky for the reasons you mentioned.
2) Where is the data that shows that considering FCF margins has had any predictive significance on market’s FUTURE stock value? You (or maybe it was Keith) are suggesting that NOW this matters…..its hasn’t previously so what are you looking at to suggest that the market is now gonna award greater valuations or stock appreciation to those truly FCF positive software stocks (normalized for SBC as Keith suggested). For example, by Keith’s chart, a company like SNOW is substantially overvalued due to its excessive SBC. But is there some actual data to prove the market is actually paying attention to FCF margins regardless as they relate to under or overvaluations??
Great newsletter, minor typo I see: paragraph 5, So what’s my take on SBC? I don’t think we should subtract it from SBC, but should instead model in future dilution as we’re calculating future returns (and therefore what multiple / price we’re willing to pay today for “fair value”).
I think you mean "I don't think we should subtract it from *FCF*..."
"So what’s my take on SBC? I don’t think we should subtract it from SBC" I think you mean FCF in the second sentence.
Thanks for the great write up. Can you share a link to Keith’s report?
Thank you for the article Jamin, this is a topic I've been spending a lot of time thinking about myself. One change that I've begun to implement is running DCF's based on FCF per share vs. on just FCF basis. By running a DCF on FCF per share you incorporate the negative impact of SBC in the dilution projections. It's slightly different than looking at the intrinsic value of the business but rather the intrinsic value of the cash flows a shareholder has rights to on a YoY basis. Running a simple 10 year DCF per share calculation sensitivity, I've found that for every incremental point of dilution leads to a ~4% valuation impact for the Company (i.e. running a normal DCF for a Company might imply $100m valuation, but if you incorporate 2% of dilution a year the intrinsic value becomes $92m).
Let me know what you think if you think this approach makes sense or any glaring holes.
IMHO, the most important part of the weekly Clouded Judgment epistle is the "NTM Rev Growth vs NTM Rev Multiple" chart. The weekly changes in the chart are intriguing! The slope of the line changes each week, indicating a relative change in perceived valuation of the SaaS market. Can you provide a comparison between the SaaS chart results and an equivalent for the Nasdaq and others?
Thanks for sharing with us all!
Could you please share a calculation example for this:?
Bottom-line from our analysis, for every additional percentage point of share dilution seen from SBC versus the industry average – 2.5% per year for 15-30% growers and 4% per year for 30%+ growers, we estimate EV/Sales multiples should be adjusted down by ~6%.”
Jamin:
Thanks for again addressing this very controversial issue of SBC. Can you link the article from Keith Weiss as I would like to study it further. Two comments from me:
1) You can argue that you don’t need to reduce FCF by the SBC but you are in effect doing just that when you follow Keith’s argument of reducing the valuation multiple. That effect would be exactly what would happen if you were doing a DCF since lowering FCF would have the impact of lowering intrinsic value and therefore the valuation multiple. So really, you ARE buying into the negative impact of SBC on FCF. I think that is exactly the proper way to think about this but certainly agree that teasing out its precise NEGATIVE impact on FCF is very tricky for the reasons you mentioned.
2) Where is the data that shows that considering FCF margins has had any predictive significance on market’s FUTURE stock value? You (or maybe it was Keith) are suggesting that NOW this matters…..its hasn’t previously so what are you looking at to suggest that the market is now gonna award greater valuations or stock appreciation to those truly FCF positive software stocks (normalized for SBC as Keith suggested). For example, by Keith’s chart, a company like SNOW is substantially overvalued due to its excessive SBC. But is there some actual data to prove the market is actually paying attention to FCF margins regardless as they relate to under or overvaluations??
SBC is now worthless for many employees with the stock implosions. Do you expect employees to start demanding more salary?
Jamin,
Great newsletter, minor typo I see: paragraph 5, So what’s my take on SBC? I don’t think we should subtract it from SBC, but should instead model in future dilution as we’re calculating future returns (and therefore what multiple / price we’re willing to pay today for “fair value”).
I think you mean "I don't think we should subtract it from *FCF*..."
Thanks
James
Hi Jamin,
Excellent SBC piece. Thank you for providing insight on such an important/timely topic.
Have you ever looked at or contemplated that SBC is two transactions? Do you think that separating SBC into an operating and financing transaction?
See a paragraph below from Dr. Sanjeev Bhojraj's paper "Stock Compensation Expense, Cash Flows and Inflated Valuations". https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3503684
"This treatment of stock compensation in the statement of cash flows has significant ramifications
from a decision making and valuation perspective. Stock compensation is essentially two
transactions: an operating transaction wherein the employee is a provider of services and a
financing transaction wherein the employee is a source of capital. Under this approach stock
compensation expense has two effects on the statement of cash flows: it would NOT be added
back as a noncash expense in the operating section; instead, it would be added as a cash inflow in
the financing section. This is particularly important given the role of CFO and FCF in internal
decision making as well as its role in valuing firms."