Too many managements will tell you the shareholder earned $2B because non-cash stock-based compensation is not a real cash expense and can be ignored. That may be correct but it’s $1B that the shareholder doesn’t get, insiders do. 1/ https://twitter.com/ChrisBloomstran/status/1320168046556827649

You see this in adjusted earnings or adjusted EBITDA presentations. Managements may also tell you they “returned” $3B to shareholders in the form of dividends and share repurchases. On a $20B market cap that’s a 15% shareholder return. All nonsense. 2/

Had the $1B in shares not been given to executives/employees, profit would have been ~$2B (ignore tax treatment). You need to know what percentage of shares outstanding are being granted each year and how many of each type (options/RSU’s/PRSU’s) are outstanding. 3/

The non-cash expense for options is determined by Black-Scholes and is typically around ~1/3 of the face value of the grant. RSU’s and PRSU’s are expensed at the value of the grant. 4/

The employee will pay the strike price to the company on exercise of options and the cash paid is seen in the cash flow statement. There is no payment to the company upon exercise of RSU’s/PRSU’s. 5/

Dilution really happens when the shares are granted, but not seen in shares outstanding until exercised. The shareholders are being diluted nonetheless, which should lend an appreciation to measuring share count on a fully diluted basis. Here’s where policy goes haywire. 6/

Too many companies offset the dilution by repurchasing shares regardless of price/valuation. A share repurchase is only helpful if made at a discount to intrinsic value. In the example, if the $2B in repurchases are made at high prices, the shareholder is harmed. 7/

The share count should be declining, increasing ownership, but if the repos are made to merely offset the dilution from options and RSU’s being exercised (and often sold), despite the shares “retired” the shareholder sees no increase in ownership. 8/

So, the shareholder made $1B, a 100% payout of profit, but is being diluted on the front end at the same rate. Had shares not been granted to execs and employees, profit for the shareholder would have indeed been $2B. 9/

The cash spent to repurchase $2B in shares either came from cash on hand, borrowed, or a combination. We don’t know if shares were issued for acquisitions. If not, the entire $2B was spent to offset, hide might be a better way of saying it, the transfer of wealth to insiders. 10/

If the repurchases are made at too high prices, the economic value of the repurchase can be less than $2B, and earnings for the shareholder are already only half of what they would be sans share grants. 11/

There are further questions of capital allocation, but if the payout is 100% of profit and profit is fairly stated, then any growth will require new capital or comes at little or no cost. At a 100% payout rate, the dividend yield matches the earnings yield. 12/

If capital is being spent to repurchase shares and your ownership position is not growing pro-rata with the capital spent to buy shares, then the dilution is even more harmful. 13/

In the example, insiders were awarded half of the operating profit in the value of new shares and the capital spent on repurchases, 100% of operating cash flow, did not increase your ownership. 14/

Few managements are disciplined enough or know enough to only repurchase shares when they are undervalued. You’ve got to understand how much of profit, properly measured, inures for your benefit as the owner. If dilution were obvious there might be pushback. No CEO wants that.15/

Despite reporting $1B in profit and receiving a dividend in that amount, the shareholder is really making the dividend plus or minus the intrinsic value differential on repurchase. 16/

The CEO that tells you profit is really $2B doesn’t go out of the way to tell you that you only own half of that, he or she gets the rest. With $2B cash out the door to buy shares, but NO reduction in the shares out, the shareholder not only made nothing but saw equity erode.17/

Equity grows by $1B in net income, shrinks by the same $1B dividend, and shrinks further by the $2B in cash spent on repos. $3B in cash left the door and $1B presumably came in. 18/

Cash, an asset, shrinks by a net $2B, plus or minus any benefit or harm from the price paid relative to value for shares in the repurchase. I could have mentioned upfront to assume the business in a steady state and capex equals depreciation. 19/

The investor needs to estimate not only the price paid relative to intrinsic value for repurchases, but also to measure the same for shares granted up front. The issuance is often more harmful than the offsetting repurchase, yet gets little attention. 20/

I hope this exercise helps illustrate how harmful dilution can be and how it can cause bad decision making. Dilution can be tolerated in a rapidly growing business, but it can also take a chunk of flesh from your ownership. Lose enough flesh and you’re dead. Caveat emptor. 21/21