Simplistically, when an employee is paid in stock, two accounting entries are made and meant to offset one another.
First, SBC is excluded from traditional calculations of non-GAAP earnings and operating/free cash flow. For instance, if a firm pays US$200 million in total compensation, ½ cash, ½ stock, then non-GAAP earnings and operating and free cash flow would be US$100 million higher than if employees were paid exclusively in cash.
Second, SBC is added to the number of diluted shares outstanding. If a firm pays out US$100 million worth of stock and its stock price is US$20, share count would increase by five million shares.
In our view, investors generally believe this offsetting mechanism makes it okay to exclude SBC from their earnings/cash-flow calculation for valuation purposes. Likewise, many companies believe it is okay to exclude SBC from key performance evaluation metrics. We disagree with both practices.