why do the absolute amounts of earnings and free cash flow look so much better for company B than company A when really $100,000 of the engineer's compensation was paid by issuing stock in both cases?
Well, because for that period and with the standard J. Shannon definition of FCF, Company A in fact has run through more cash. Although you asked not to talk about share counts, Company A has a double penalty since it has now issued more shares to get that extra $100K, diluting its pre-existing shareholders, and if Company B's engineers haven't exercised their options, on a primary # of shares, Company B's shareholders think they are less diluted.
Huey, I think you totally have a handle on this, and your example demonstrates how conventional measures of FCF and GAAP earnings kinda miss the boat on what's really happening to the shareholders. Obviously, at least in the short run, Company B will have much better eps (assuming positive net income) than Company A, even though in your example the common shareholders of A and B are, in reality, equally well off.
I further agree with you that expensing the stock options via Black-Scholes is not the entire answer to get A and B on the same playing field, since as you said the Black-Scholes expense will just get added back to GAAP earnings to get cash flow from operations.
It's maybe half the answer because while it gets A & B's GAAP earnings the same on an aggregate basis, it still misses on primary eps, and reported cash flow from operations remains unequal. So I'm struggling with this too, which is why I started to look at the activity in the equity section as being important parts of the equation, and that real FCF isn't just cash flow from ops less investment in replacement fixed assets. Looks to me that you've done an elegant job showing the case.
More ramblings...
Maybe "Black-Scholes" expense should not be added back to GAAP earnings, when options are expensed, to determine FCF - and the proper treatment would be to treat it as a cash flow from a financing activity. Probably ought to look at Boeing to see how they treat it - but it really would be misleading to add it back to ops versus a financing event - after all, it's how payroll got financed.
Further, not quite to Huey's example, but what would happen if the calculation of fully diluted shares were adjusted by the theoretical number of shares derived by dividing the Black-Scholes expense amount by the market price of common as of the date of grant? I'm thinking that if the options were expensed on the P&L and the number of fully diluted shares were adjusted on the date of grant, you might get to a more accurate answer on a fully diluted eps basis, and if the Black-Scholes expense were treated as a financing activity rather than as an add back to cash flow from ops, the cash flow statement would be more accurate. |
