Stock-based compensation

Stock-based compensation is the fair-value cost of equity awards — options, restricted stock units, performance shares — granted to employees. It is a real economic expense from the shareholder's perspective: an option grant transfers economic ownership without any cash leaving the company, but it dilutes existing shareholders' claim on future cash flows. Accounting standards (ASC 718, IFRS 2) require SBC to be expensed through the income statement at fair value at grant, which means it already flows through reported net income and EPS. The two valuation pitfalls. First, SBC is added back as a non-cash item on the cash-flow statement, which inflates operating cash flow and (by extension) free cash flow. We adjust by subtracting SBC from FCF in our valuation models, particularly for software businesses where SBC can run 15–25% of revenue. Second, do not double-count: in the owner-earnings construct, SBC is already in net income and should not be subtracted again. The clean adjustment is what we call 'excess-only': subtract SBC above the sector median, on the theory that base-rate SBC is a wage substitute and only the excess represents genuine equity dilution.