Stock-based employment compensation has gained popularity in recent years, and even investors who don’t receive employment compensation in stock should be asking, is SBC potentially dilutive to shareholders?

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Welcome to Thoughts on the Market. I'm Todd Castano, Head of Global Valuation, Accounting and Tax within Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the interesting conundrum around stock based compensation. It's Friday, May 13th at 2 p.m. in New York. 

I don't need to tell listeners that 2022 has been rough on equity prices. And while it may be difficult to look at the double digit drop in the S&P or on your 41k, I'm going to share an interesting ripple effect from the market correction. And that's the impact on employee stock based compensation. And while some listeners may be saying, "this doesn't affect me because I don't receive compensation in stock", it doesn't mean it's not having an effect on your portfolio. But let me start at the beginning. 

For those unfamiliar, stock based compensation, often called SBC, is a form of compensation given to employees or other parties like vendors in exchange for their services. It's a very common way for companies to incentivize employees and to align employee and shareholder interest. When a company does well, everyone does well. Stock options, restricted stock, restricted stock units are currently the most common types of stock based compensation. 

Stock based compensation issuance has gained in popularity, particularly with startups and new issuances, allowing companies without much cash on hand to offer competitive total compensation rates and to attract and retain talent. In fact, 2021 marked the largest annual growth percentage in SBC cost at 27% year over year. Primarily because of new entrants to the equity market through initial public offerings and from the recovery from COVID that triggered performance based bonuses. Let's put a number on it. Stock based compensation is now approaching $250 billion annually, mostly concentrated in technology and communication service sectors. 

So here's where it gets interesting. While stock based incentives encourage employees to perform, they also don't require upfront cash payments. It follows that they also dilute the ownership of existing shareholders by increasing the potential number of shares outstanding. 

So now you may see where I'm going with this in terms of shareholders and your portfolio. While companies have been issuing more stock awards to employees, the double digit year to date decline in equity market has put a lot of these awards underwater. In other words, employees are essentially being paid less, meaning stock based compensation could have the opposite effect, lowering morale and sending some employees to the exits. 

To put another number on it, we estimate nearly 40% of Russell 3000 companies currently are trading below their average stock grant values. Healthcare technology firms in particular appear most exposed. And considering we're in a tight labor market, companies may be forced to issue more grants to offset equity value decreases, further diluting ownership to existing shareholders. 

I point all this out because SBC is generally treated as a non-cash expense and ignored from earnings. Market data vendors also often exclude outstanding awards from market capitalization calculations. So investors may underappreciate the potential dilution SBC brings to their shares. With more dilution on the way as companies attempt to right size employee pay. 

For investors, we believe stock compensation is a real economic expense and should be incorporated in valuation. It may not appear so in bull markets, but this correction has eliminated that reality. 

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