I’ve written numerous articles about stock-based compensation in the past for a few reasons.
For one, it’s super common. Almost every major tech company in the world pays some form of stock-based compensation to employees. Two, stock-based compensation is the silent killer that destroys shareholder value beneath the surface.
Yet despite these two facts, shareholders still do not seem to fully understand stock-based compensation and the massive impact it has on shareholders.
In this article, I want to show you just how bad stock-based compensation can be for shareholders and why it deserves more attention from investors.
Covid darling
Let’s use the one-time Covid darling, Zoom Communication Inc, as an example. As you probably know, Zoom is a video conferencing software company whose business simply exploded during the COVID lockdowns. Revenue soared and its share price rocketed.
But as the world reopened, Zoom’s growth also stalled and its share price has since come back down to pre-COVID levels.
Today, Zoom is guiding to generate free cash flow of US$1.7 billion for FY2027 (fiscal year ending January 2027). That’s still a decent number, which shows that Zoom continues to be a strong business in the aftermath of COVID.
Investors love using free cash flow to measure a company’s profitability as free cash flow is the cash generated from operations minus cash spent on capital expenses.
In theory, this is cash that can be returned to shareholders via dividends. However, free cash flow does not take into account stock-based compensation.
The hidden cost
Stock-based compensation is the hidden cost that eats into shareholder returns.
In FY2026, Zoom granted 10 million shares to its employees. These are shares that will vest over the next 3-4 years. We can assume that based on Zoom’s grant history, around 10-11 million shares will vest each year. In FY2026, for example, 11 million shares vested.
Zoom has an active share buyback plan. In aggregate, it is buying back more shares than is vesting. But that also means Zoom is actively using its free cash flow to offset the shares that vest – the cost to shareholders is immense!
To buy back the 11 million shares that vested in FY2026, Zoom has to pay around US$1.14 billion (based on its current share price of US$104).
Earlier, I mentioned that Zoom is expecting to generate US$1.7 billion in free cash flow in FY2027. If management decides to offset the stock-based compensation by conducting buybacks, the remaining cash left over for shareholders is less than US$600 million.
Valuations change
Stock-based compensation can, hence, make a huge difference to how we value a company.
In Zoom’s case, the company’s free cash flow of US$1.7 billion looks healthy on the surface and its current market cap of US$31 billion represents a somewhat decent valuation of 18 times free cash flow.
But if you account for the cash that will simply vanish from shareholders’ hands just to offset dilution, the company now only has around US$600m to return to shareholders.
This changes the picture completely. After making this adjustment, at a US$31 billion market cap, Zoom trades at much less palatable 51 times adjusted free cash flow.
The Good Investors Take
Stock based compensation is often the silent killer that destroys shareholder value – more so for companies that rely heavily only on stock-based compensation. As such, the headline free cash flow figure may not present the full picture of how profitable a business is.
Zoom is already a slow growing, mature company. Yet it is still off-setting stock-based compensation with a large part of its free cash flow.
The key thing for investors to note is how much cash can a company actually return to shareholders, once all employees’ stock-based compensation is offset. Only then, can investors truly gauge how much cash is left over for investors.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.