Their true numbers are blurred by huge share awards to employees.
Finance theory says a company is worth the present value of its future cash flows to shareholders. But that’s not how it works in practice sometimes.
Accountants focus on earnings, not cash flow and while you’d think it’s only due to timing differences that equal out over time – say once capital expenditure has been fully depreciated – large differences can exist.
One reason is that cash flow statement disclosures vary according to the accounting standards followed. For example, under the US GAAP standard, interest received or paid is included in operating cash flow. In IFRS – the international equivalent – it can be in either operating, investing or financing cash flow, as long as it’s consistently applied.
The term free cash flow (FCF) is defined by the CFA Institute – the renowned investment professional body – as the ‘cash flows available for distribution to shareholders’, operating cash flow less capital expenditure. However, it may surprise some investors to also know that this widely quoted term and metric isn’t actually approved by accountants. Yet this non-GAAP measure in the US is very popular, especially with technology companies.
Fair (or unfair) shares
One reason for its popularity among these companies is the treatment of ‘stock-based compensation’ (SBC) which Morgan Stanley estimated to be worth $270bn in 2022.
When a company gives employees shares or share options in the business, no cash changes hands – meaning it’s excluded in the calculation of FCF. The trouble is that the accountants think there’s a cost to that award and they want that cost included in the calculation of GAAP income. Rightly so in our opinion.
So what is that cost?
The accountants calculate it as being the ‘fair value’ of the shares or options at the time of the initial grant. That’s a good start, but we’d argue the true cost is the dilution ordinary shareholders suffer from all the additional shares being issued to staff because they will receive a lower proportion of future cash flows
If you agree with this logic, then the real cost of the grant is what it costs to offset this dilution. In other words, what it would cost to buy back those shares that were gifted to staff to offset the dilution.
The good news is that many technology companies are buying back shares to offset this dilution. The bad news is that this is far higher than the stock based compensation charge that was included in the income statement at the time of the grant. This is because the fair value of the grant is calculated using option pricing theory which anticipates a random walk rather than a one-way bull market.
When these companies talk about SBC they take the operating cash flow less the capital investment. The share option cost is nowhere in these two line items.
Going meta
Over the past four quarters, Meta generated $49bn of free cash flow including $15bn of SBC expense that was added back to net income to calculate this number.
Conventional valuation suggests that Meta is trading on an FCF yield of 3.3% ($49bn vs its market cap of $1.45tn). But over the past year, Meta has spent 84% of this FCF ($41bn) repurchasing shares. Unfortunately, the fully diluted shares in issue only declined by 0.1% so by my calculation, that’s closer to a 0.6% FCF yield.
So although Meta bought back 80m shares, they issued almost as many new shares to staff neutralising the anti-dilutive effect of their buyback. And as of 30 June, staff still held a further 152.7m unvested shares which would cost a staggering $89bn to repurchase at current prices and prevent any dilution to ordinary shareholders. That’s almost twice last year’s net income by which time even more shares will be issued.
Since technology company share prices have risen, the historic cost of the awards is a fraction of the cost of neutralising these awards today with buybacks – Meta’s average SBC cost over the past three years has been ‘only’ $13.6bn. And yet it is this far lower cost that has been excluded in FCF calculations
But Meta isn’t alone.
Nvidia has generated $47bn of FCF and spent 45% ($21bn) repurchasing shares. Fully diluted shares have only fallen 0.6%. As of 28 July, there were 348m equity awards outstanding that would cost a net $35bn to repurchase but Nvidia’s SBC charge has averaged ‘only’ $3.4bn p/a over the past three years.
The reason for the particularly large difference between the income statement cost of $3.4bn and the real cash cost to shareholders of well over 10 times this number is the very strong performance of the Nvidia share price. Nonetheless, it is now a real cash cost that is borne by current Nvidia shareholders.
Taking stock
Vast amounts of the FCF being generated by these technology companies are not going to shareholders but essentially going to staff to offset the dilution of their share awards. In our opinion, the FCF calculation wrongly ignores this cost and therefore we think the true FCF yields are far lower than many believe.
These are fabulous businesses, but to us, it seems they’re being run for staff not shareholders – and that’s why the Ranmore Global Equity Fund doesn’t currently hold shares in Meta, Nvidia, or indeed in any of the Magnificent Seven.