Last week, I listened to an interview with Kevin Koharki. The topic was something I’ve been thinking about for over a year: how does stock-based compensation (SBC) impact shareholders of public companies? When I review the financial statements of public technology companies, I see that they have large amounts of SBC expense, but it’s a noncash expense. So, many people back it out and focus on cash flow from operations, free cash flow, or adjusted EBITDA. But that SBC must be paid to employees in cash at some point (assuming the stock performs well), so how is it accounted for?

I’ve leaned toward using diluted share count instead of shares outstanding when calculating free cash flow or potential free cash flow per share. But Kevin thoroughly explained how SBC materially reduces operating and free cash flow of companies that offset SBC dilution by repurchasing shares (i.e., doing buybacks). He does a great job of walking through a real-life example of a company and showing where on the financial statements you can find the information you need to determine how SBC affects cash flow per share. The biggest thing I learned from Kevin was that in some companies, shareholders get hit twice: when companies issue SBC and when they do buybacks. And that second hit isn’t accounted for on the income statement or cash flow from operations. I hadn’t considered this, but when he walked through it, it made a lot of sense.

Kevin is spot on, but I will say that two assumptions underpin the worst-case scenario in his argument. He assumes the stock price will be higher when employees cash in their SBC and the company repurchases shares. That’s been true the last few years, but historically it isn’t always true. The stock market has long periods of underperformance (e.g., 1964–1981). Companies can’t control the prices at which employees sell shares, but they have total control over the price they pay to buy back shares. The smartest CEOs repurchase shares only when the stock is suppressed because the stock is likely trading for less than it’s worth, meaning the returns on buybacks are often higher than capital allocation alternatives. Henry Singleton mastered this, and it’s a big part of why Warren Buffett praised him and why Teledyne’s shares outperformed (learn more here). If a company repurchases shares at materially lower prices than when SBC was issued and doesn’t issue additional SBC to employees to compensate for the lower stock price, it’s likely a benefit to the company. Those are two big ifs, though, especially the second one.

The second assumption is that companies that issue SBC are buying back shares to offset the dilution created by SBC. That’s true of many companies, but not all. Some companies don't repurchase shares. Instead, they focus on minimizing share dilution by limiting share count growth to a low single-digit percentage each year and improving the underlying fundamentals of the business. One company I track increases share count by 2% to 3% a year via SBC, but it’s growing top-line revenue, operating cash flow, and free cash flow at 30% or more annually. The company hasn’t repurchased any shares to date. Thus, the business fundamentals are increasing at a rate that far outpaces the share dilution from SBC. Said differently, the intrinsic value of the company is growing at over 30% annually, while shareholders are being diluted roughly 3% annually. It’s true that 3% dilution means investors own 3% less of the pie each year, but that’s not as much of an issue when the pie is 30% larger each year.

I think Kevin is on to something and that more people will start to pay closer attention to this in 2026. Anyone interested in how SBC works or how it impacts shareholders should consider watching Kevin’s interview here.