The Pitfalls of Using IRR

IRR is a useful calculation but it has its limitations.

The internal rate of return (IRR) is a commonly used metric to estimate the profitability of an investment. It can be used to assess whether an investment is worth making or not. It is also used to assess the performance of investment funds, such as venture capital and private equity funds.

However, an IRR can be somewhat misleading and actual returns can differ significantly from what the IRR shows you. This is because the IRR only calculates the return on investment starting at the point when cash is deployed. In many funds, cash may not be deployed immediately, which results in a cash drag that is not accounted for in the IRR calculation.

The IRR also makes an assumption that the cash generated can be redeployed at the calculated IRR rate. This is often not the case.

Here are some examples to illustrate these points.

Cash drag

Venture capital and private equity funds are unique in that investors do not give the committed capital to a fund immediately. Instead, investors make a commitment to a fund. The fund only asks for the money when it has found a startup or company to invest in; this is called paid-in capital, which differs from committed capital.

To calculate returns, venture capital and private equity funds use the IRR based only on paid-in capital. This means that while the IRR of two venture funds can look the same, the actual returns can be very different. Let’s look at two IRR scenarios below:

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	IRR
Fund A	-$1000	0	0	$2000	0	0	26%
Fund B	0	0	-$1000	0	0	$2000	26%

Both Fund A and Fund B have an IRR of 26%. The difference is that Fund A deployed the capital straight away while Fund B only found an investment in Year 3. Investors in Fund A are actually much better off as they can then deploy the $2000 received in Year 3 into another investment vehicle to compound returns. Fund B’s investors, meanwhile, had a cash drag with committed capital that was not deployed in Year 1 and 2, and this drag is not recorded in the IRR calculation.

Wrong assumptions

The IRR formula also assumes that the cash returned to investors can be redeployed at the IRR rate. As mentioned above, this is not always the case. Take the example below:

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	IRR
Investment A	-$1000	$300	$300	$300	$300	$300	15.2%
Investment B	-$1000	0	0	0	0	$2025	15.2%

In the above scenario, both Investment A and Investment B provide a 15.2% IRR. However, there is a difference in the timing of cash flows. Investment A provides cash flow of $300 per year while Investment B provides a one-time $2025 cash flow at the end of Year 5. While the IRR is the same, investors should opt for Investment B.

This is because the IRR calculation assumes that the cash flow generated can be deployed at similar rates as the IRR. But the reality is that oftentimes, the cash flow can neither be redeployed immediately, nor at similar rates to the investment.

For instance, suppose the cash flow generated can only provide a 10% return. Here are the adjusted returns at the end of Year 5 for Investment A

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	IRR
Investment A	-$1000	$300	$300	$300	$300	$300	15.2%
Investment A (adjusted)	-$1000	0	0	0	0	$1832	12.9%
Investment B	-$1000	0	0	0	0	$2025	15.2%

I calculated $1832 by summing up the cash flows with the extra returns generated by investing the cash flows at a 10% rate. As you can see, after doing this, the returns generated from investment A now fall to just 12.9% vs the 15.2% previously calculated.

The bottom line

Using the IRR to calculate investment returns is a good starting point to assess an investment opportunity. This can be used for investments such as real estate or private equity funds.

But it is important to note the limitations of the IRR calculation. It can overstate or understate actual returns, depending on the timing of the cash flows as well as the actual returns on the cash generated.

A key rule of thumb is that the IRR is best used when cash can be deployed quickly so that there is minimal cash drag, and when the cash generated can be deployed at close to the IRR of the investment. If this assumption does not hold true, then a manual calculation of the returns of the investment need to be made by inputting the actual returns of the cash generated.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any companies mentioned. Holdings are subject to change at any time.

Applying The Lessons Learnt From 2021

Don’t make the mistakes of the past.

With stock markets making new highs this year, it is a good time to look back at the lessons learnt from the collapse of some tech stocks in 2021 and 2022.

Back then, stock markets also reached all-time highs but many tech names collapsed as valuations compressed and growth stalled.

With this in mind, here are some of the key things to be mindful of today as we navigate the stock market.

Don’t celebrate too soon

Investing is a long game. Just because our stocks have risen does not mean we have won the game. The true test of a business’s strength is its enduring ability to keep on growing. Stock prices may also reflect unwarranted short term optimism which does not materialise.

Make sure to continuously assess the fundamentals of your portfolio companies even (especially) if its stock price has skyrocketed.

Don’t chase stocks

It may be tempting to buy stocks that have risen greatly in a short period of time. Afterall, none of us want to be left out of a massive rally.

But this fear of missing out can work against us as stocks don’t keep going up forever. Remember that valuations matter and we need to assess if a stock has gone up too much over a short period of time.

In 2021, many stocks rose to unsustainable valuations, only to come crashing down to earth in the next two years. While some have recovered, many still linger up to 90% off their all-time highs.

Sell if valuations don’t make sense

Buy-and-hold is a great strategy when markets are working smoothly and you’ve bought into great growing companies at reasonable valuations.

But when stock markets are not working well and stock prices rise too high due to unwarranted exuberance, it may be important to look at your sell strategies.

Back in 2021, the stocks of many companies skyrocketed. It was not uncommon to see stocks rise by up to 1,000% in a short period of time.

While some of these companies are undoubtedly growing fast and are resilient, the valuations reached a point where forward returns would likely be depressed. Unsurprisingly, many of these companies’ stocks plunged and have yet to recover.

Growth trends may not continue

It may be tempting to look at a company’s recent revenue and profit growth and assume that it can continue growing at that rate for a long period of time. The reality is that future growth trends may not always mirror the past. This is especially true for companies that have been growing at unsustainably high rates. More often than not, growth will fall back to more normal rates.

The poster boy of the COVID collapse is probably Zoom Communications. The company saw explosive growth, only for its growth rates to flat-line once the pandemic ended.

Besides Zoom, there are numerous other companies that also saw growth decelerate meaningfully as we exited the pandemic era.

These companies unsurprisingly have seen their stock prices collapse.

Look for recurring revenue

Many companies can experience significant upmarkets due to upgrade cycles or loose monetary policy which encourage unsustainable consumer and business spending. However, remember that many companies do experience significant swings in revenue because of the cyclical nature of their end-demand. This may be more true for hardware companies or those that sell big ticket items.

Companies such as Enphase, which sells solar power products such as microinverters, have seen their revenues crater as distributors struggle to clear inventory because of weak end-customer demand.

Bottom line

Although it is nice to see stock prices rise significantly in the past two years, it is important that we remember the key tenets of value investing. The above mistakes are some that many of us have made before.

This time around, let’s try to ensure that we maintain a portfolio of stocks that have good valuations and whose business can continue to thrive in good times and in bad.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Zoom Communications. Holdings are subject to change at any time.

The Buyback Endemic

Buying back stock at unreasonably high valuations is not a good use of capital and can destroy shareholder value.

Buybacks can be a good way for companies to enhance shareholder value. Share buybacks reduce the number of shares outstanding, allowing companies to pay a higher dividend per share in the future.

But not all buybacks are good. Done at the wrong price, buybacks can actually be a bad use of capital. In fact, I have seen so many companies do buybacks recklessly and without consideration of the share price.

The problem probably arises from a few reasons.

Wrong mindset

First, some executives do not have a good grasp of what buybacks are. Take this statement from Tractor Supply’s management in its 2024 second-quarter earnings report for example:

“The Company repurchased approximately 0.5 million shares of its common stock for $139.2 million and paid quarterly cash dividends totaling $118.5 million, returning a total of $257.7 million of capital to shareholders in the second quarter of 2024.”

The issue with this statement is that it lumps dividends and share repurchases in the same bracket. It also implies that share repurchases are a form of returning capital to shareholders. The truth is that share repurchases is not returning cash to long-term shareholders but only to exiting shareholders. If management mistakes repurchases as capital return, it may lead them to do buybacks regularly, instead of opportunistically.

Although I am singling out Tractor Supply’s management, they are just one out of many management teams that seem to have the wrong mindset when it comes to buybacks.

Incentives

Additionally, executive compensation schemes may encourage management to buy back stock even if it is not the best use of capital.

For instance, Adobe’s executives have an annual cash remuneration plan that is determined in part by them achieving certain earnings per share goals. This may lead management to buy back stock simply to boost the company’s earnings per share. But doing so when prices are high is not a good use of capital. When Adobe’s stock price is high, it would be better for management to simply return dividends to shareholders – but management may not want to pay dividends as it does not increase the company’s earnings per share.

Again, while I am singling out Adobe’s management, there are numerous other companies that have the same incentive problem.

Tax avoidance

I have noticed that the buyback phenomena is more prevalent in countries where dividends are taxed.

The US, for instance, seems to have a buyback endemic where companies buy back stock regardless of the price. This may be due to the fact that US investors have to pay a tax on dividends, which makes buybacks a more tax-efficient use of capital for shareholders. On the contrary, Singapore investors do not need to pay taxes on dividends. As such, Singapore companies do not do buybacks as often.

However, simply doing buybacks for tax efficiency reasons without considering the share price can still harm shareholders. Again, management teams need to weigh both the pros and cons of buybacks before conducting them.

Final thoughts

There is no quick fix to this problem but there are some starting points that I believe companies can do to address the issue.

First, fix the incentives problem. A company’s board of directors need to recognise that incentives that are not structured thoughtfully can encourage reckless buybacks of shares regardless of the share price.

Second, management teams need to educate themselves on how to increase long-term value for shareholders and to understand the difference between buybacks and dividends.

Third, management teams need to understand the implications of taxes properly. Although it is true that taxes can affect shareholders’ total returns when a company pays a dividend, it is only one factor when it comes to shareholder returns. Executive teams need to be coached on these aspects of capital allocation.

Only through proper education and incentives, will the buyback endemic be solved.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Adobe and Tractor Supply. Holdings are subject to change at any time.

Assessing Different Share Buyback Strategies

Buying back stock is a great way to drive shareholder value but only if it is done at the right price.

Over the past few years, I have observed the different ways that companies conduct their share buybacks. This made me realise that the way a company conducts its share buybacks can have a profound impact on the long term returns of its stock.

Here are some share buyback strategies and what they mean for shareholders.

Opportunistic

The best way to conduct share buybacks is what I term as opportunistic buybacks. This means buying back shares aggressively when shares are undervalued and vice versa.

An example of a company that does this very well is the US-listed company Medpace, which helps drugmakers run drug trials.

In 2022, when markets and its own stock price were down, Medpace took the opportunity to buy back its shares aggressively. The company tapped the debt markets to procure more capital to buyback shares, to the extent that its net-cash position of US$314 million at the end of 2021 flipped to a net-debt position of US$361 million as of 30 June 2022.

But as its stock price went up, Medpace became less enthusiastic about buying back shares and instead started to pay off the debt it incurred; the company ended 2022 with a lower net-debt position of US$180 million

This type of opportunistic buyback strategy is the most efficient buyback strategy in my opinion.

The plot below shows the amount spent by Medpace on buy backs over the last 3 years.

With its stock price now at a much higher level, Medpace has not conducted buybacks for the last four quarters. Medpace’s management team is likely waiting for its shares to fall to a lower valuation before they conduct buybacks again.

Regular buybacks

Another way to conduct buybacks is to do it on a regular basis. The parent of Google, Alphabet, is one such company that has conducted very regular buybacks. In the past 10 quarters, Alphabet has consistently spent close to US$15 billion a quarter on buybacks. This includes quarters when the company’s free cash flow was less than US$15 billion.

Although I prefer opportunistic buybacks, regular buybacks may be best suited for a company such as Alphabet which has to deploy large amounts of capital. Alphabet’s shares have also consistently traded at a reasonable valuation over the last few years, making regular buybacks a decent strategy.

The chart below shows the amount that Alphabet spent on buybacks in each quarter for the last 10 quarters.

Poor timing

At the other end of the spectrum, some companies try to time their buybacks but end up being aggressive with buybacks at the wrong time.

Take Adobe, the owner of Photoshop, for example.

Adobe seems to change the level of aggressiveness in its share buybacks from quarter to quarter.

In the first quarter of 2022 , Adobe’s stock price was close to all-time highs, but the company was very aggressive with buybacks and spent more than US$2 billion – or 143% of its free cash flow in the quarter – to repurchase its shares.

When its stock price started falling later that year, instead of taking advantage of the lower price, Adobe surprisingly cut down on its buybacks to slightly over US$1 billion a quarter, less than what it generated in free cash flow during those periods. So far in 2024, Adobe has again increased its buybacks after its stock price increased.

The optimum strategy would have been to do more buybacks when its stock price was low and less buybacks when its stock price was high.

Bottom line

Buybacks can be a great way to add value to shareholders. However, it is vital that companies conduct buybacks at low valuations to maximise the use of their capital to generate long term returns for shareholders.

Medpace is an excellent example of great capital allocation, even going so far as to tap the debt markets to be even more aggressive with buybacks when its stock price is low. In the middle, we have companies such as Alphabet that consistently buyback shares. But on the other end of the spectrum is Adobe that seems to become more aggressive with buybacks at the wrong times.

Hopefully, more companies can follow in the footsteps of Medpace and make sure they put their capital to use only when the time is right.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Adobe, Alphabet, and Medpace. Holdings are subject to change at any time.

No, Dividends Are Great

Dividends are the fruits of our investments and are what makes investing in companies so profitable.

In recent times, large American technology companies such as Meta Platforms, Salesforce, and Alphabet have initiated a dividend.

It’s easy to imagine that their shareholders would be pleased about it, but this isn’t always the case. Some shareholders are actually disappointed about the dividend announcements. They think that the companies have nowhere else to invest their capital and are thus returning it to their shareholders. In other words, they think that the companies’ growth potential have stalled.

But I see things differently. Dividends are ultimately what we, as shareholders, invest in a company for. Long-term shareholders are here to earn a cash stream from investing in companies. This is akin to building your own business which generates profits which you can cash out and enjoy. As such, dividends are the fruits of our investment.

And just because a company has started paying a dividend does not mean it can’t grow its earnings. Just look at some of the dividend aristocrats that have grown their earnings over a long span of time. There are many companies that can generate high returns on invested capital. This means that they can pay out a high proportion of their earnings as dividends and still continue to grow.

Dividends can compound too

For investors who don’t want to spend the dividend a company is paying, they can put that dividend to use by reinvesting it.

When a company is not paying a dividend, its shareholders have to rely on management to invest the company’s profits. When there’s a dividend, shareholders can invest the dividend in a way that they believe give them the highest risk-adjusted return available. Moreover, a company’s management team may not be the best capital allocators around – in such a case, when the company generates excess cash, management may invest it in a way that does not generate good returns. When a company pays a dividend, shareholders can make their own decisions and do not have to rely on management’s capital allocation skills.

And if you think the company was better off buying back shares, you can simply buy shares of that company with your dividends. This will have a similar effect to share buybacks as it will increase your stake in the company.

What’s the catch?

Dividends have some downsides though.

Compared to buybacks, reinvesting dividends to buy more shares may be slightly less effective as shareholders may have to pay tax on those dividends. For example, Singapore-based investors who buy US stocks have to pay a 30% withholding tax on all US-company dividends.

The other downside is there’s more work for shareholders. If management was reinvesting prudently and not paying dividends, shareholders wouldn’t need to make a decision. But with dividends, shareholders have to decide where and when to reinvest that dividend. This said, it does give shareholders more options and opens up possibilities of where the dividend can be invested, instead of just relying on management. To me, I would happily take this tradeoff.

Don’t fret

Dividends are good. It’s funny that I even need to say this.

Dividends are the fruits of our investments and are what makes investing in companies so profitable. Without it, we will just be traders of companies, and not investors.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Alphabet, Meta Platforms, and Salesforce. Holdings are subject to change at any time.

Identifying Value Traps

Value traps are stocks that may look cheap but are actually expensive.

Investors often use valuation metrics to screen for “cheap” or “undervalued” companies. Identified correctly, undervalued companies will provide better returns than the broader market.

However, we can often fall into the trap of believing a company is cheap if we are overly reliant on using common valuation metrics that may be misinterpreted.

Since I started investing, I have come across numerous value traps and thought it would be useful to put together a short list of common value traps to be avoided.

Low earnings multiple but unstable earnings

This is probably the most obvious value trap. A company that trades at a low earnings multiple – i.e. a company with a market capitalisation that is relatively low compared to its past earnings – may look cheap. But if its earnings are not sustainable, it may become a really bad investment.

Moderna and BioNTech both had massive earnings boosts from selling COVID vaccines in 2021 and 2022. But both have also seen their earnings plummet since. Investors who looked at their historical earnings multiples during the COVID-boom may get the idea that they were cheap, but the COVID-induced profits were not likely to be repeated.

Looking at a company’s historical earnings can give investors some idea of its profitability. But the past does not always mirror the future and investors need to think about a company’s future earnings too.

High but unsustainable dividend yield

A company with a high trailing-twelve-month dividend yield can seem enticing. But it could still end up as a value trap if its dividend is not sustainable. What makes a dividend sustainable? Some good questions to ask include:

Is the dividend supported by a regular profit stream?
Is the dividend a one-off special dividend that will not recur?
Is the dividend payout ratio above 100%?
Does the company have a predictable and recurring revenue stream?

All of these questions help us to identify if a company is a sustainable dividend payer or simply a dividend value trap.

Lots of cash, but with a cash-burning business

Investors may get attracted to a company that has lots of cash on the balance sheet. The company is even more enticing if its net cash positive is a large percentage of its market capitalisation. But the balance sheet is not an indicator of the quality of a business.

A company with a lot of cash on the balance sheet can still end up as a value trap if it has a weak business that constantly burns cash. For instance, there are numerous biotech companies in the US stock market that look promising with high net cash balances but that are burning lots of cash to research potential drugs. Although some of these biotechs may end up getting FDA approval for their drugs and become winners, a vast majority of them will end up with unfeasible drugs and a cash balance that has been wiped out after years of unfruitful research.

A management that won’t return cash to shareholders

What’s a company with lots of cash on the balance sheet, a stable and profitable business, trades at low earnings multiple, but management refuses to return cash to shareholders? It is a potential value trap.

There is no point in having a stable and recurring business generating lots of cash but shareholders will never see that cash. This is a common situation in companies listed in Singapore and Japan, where corporations retain too much cash on the balance sheet.

This phenomenon may happen because a company is majority family-owned and the family does not need the cash as dividends. Or the management team may be ultra-conservative and retain cash unnecessarily. Either way, shareholders are left with nothing or have to wait decades to see their cash.

Final word

It does not make sense to invest in a company at a price that’s significantly higher than its intrinsic value. But just searching for companies with low valuation metrics does not mean you will end up with bargains. It pays to recognise the existence of value traps.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in any stocks mentioned. Holdings are subject to change at any time.

Have Apple’s Share Buybacks Been Good For Shareholders?

Apple has used a staggering amount of cash to buyback shares. Has it been a good use of capital for shareholders?

Apple has spent a whopping US$651.4 billion on share repurchases from September 2011 to December 2023.

For perspective, Broadcom, the 9th largest company listed on the US stock market, currently has a market cap of US$617 billion. Apple could have bought the 9th largest listed company in the US using the cash it spent on buybacks. This brings us to the question, were Apple’s share buybacks the best use of its cash?

How much return did the buybacks create?

To judge if Apple made the right decision, we need to look at how much earnings per share growth the buybacks achieved.

Back in September 2011, Apple had roughly 26 billion shares outstanding on a split-adjusted basis. As of 20 October 2023, the date of the regulatory report for the fiscal year ended 30 September 2023 (FY2023), Apple had 15.55 billion shares outstanding. This is a 40% drop in shares outstanding. The lower share count, achieved through buybacks, has had a profound impact on Apple’s earnings per share.

In FY2023, Apple generated US$97 billion in net income and US$6.13 in diluted earnings per share. If the buybacks didn’t happen and Apple’s shares outstanding remained at 26 billion for FY2023 – instead of 15.55 billion – its diluted earnings per share would only be US$3.73 instead of US$6.13. Said another way, if Apple opted not to reduce its share count, the company would have needed its net income in FY2023 to be higher by US$62 billion in order to generate a similar diluted earnings per share figure.

So, Apple’s US$651 billion investment in share buybacks has created US$62 billion in “annual net income” to the company, and possibly more in the future as Apple’s net income continues to climb.

Could it have done better?

Although it’s clear now that Apple’s buybacks have had a positive impact on its diluted earnings per share, the next question is if the buybacks were the best use of the company’s capital.

Broadcom, the company whose market cap is close to the cumulative amount Apple has spent on buybacks, generated net income of US$14 billion in its most recent fiscal year.

If Apple had bought Broadcom instead, it would only have generated US$14 billion more in net profit, far less than the implied US$62 billion growth achieved from buying back its own shares. This would have resulted in substantially less earnings per share growth than the buybacks. In comparison, Apple’s buybacks seem like a good investment decision.

I know that using Broadcom as an example may not be the best comparison as Apple could have bought Broadcom for much less in 2012. Nevertheless, it gives some perspective on the different possible uses of capital.

Conclusion

Was buybacks the single best use of cash for Apple? Probably not. But was it a bad investment? Definitely not. The return on investment through Apple’s buyback program has resulted in a large jump in its earnings per share. The US$62 billion “increase” in annual earnings could also continue to rise if Apple’s earnings grows over time. Although there could possibly have been better investments, I think Apple made a decent decision to focus on buybacks over the past few years.

But should Apple continue buying back shares? This is the question on everyone’s lips right now, especially with Apple recently announcing a new US$110 billion buyback authorisation.

Buybacks provide a good return only if shares are trading at cheap valuations. Apple’s management needs to continue evaluating the company’s valuation when making future buyback decisions. With Apple’s valuation increasing in the past few years, management will need to decide if conducting buybacks today still provides good value for shareholders or if other forms of investments will be more impactful.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Apple Inc. Holdings are subject to change at any time.

Different Types of Stock-Based Compensation and What Investors Need to Know About Them

Stock based compensation can come in many forms. Here are some that most commonly used and what they mean for investors.

I’ve been studying stock-based compensation across a wide range of companies for a few years now.

One thing I’ve learnt is that stock-based compensation can come in a variety of different forms. Each will have a different impact on the future cash flows from a company that accrues to shareholders.

With this in mind, here is a short primer on four of the most common types of stock-based compensation and how they impact the shareholder.

Restricted stock units

Restricted stock units, or RSUs, is the most common form of stock-based compensation I’ve encountered. It is essentially the issuance of new shares to employees.

Well-known companies such as Meta Platforms and Zoom Video Communications issue RSUs to employees. Typically, employees are given RSUs when they join the company. However, these RSUs only turn into shares – or “vest” – over a period of time. Only when they vest can an employee sell them or receive any dividends from holding them.

You can find the number of RSUs outstanding for a company on the notes section of their financial reports . By looking at the RSUs outstanding, you can gauge what is the future diluted share count once all these RSUs have vested.

Options

Another common form of stock-based compensation is options. Options give employees the right to buy new shares of a company at a predetermined price by a certain date.

The good thing about options for shareholders is that unlike RSUs, the company receives cash when these options are exercised. This increases the company’s cash balance and if the exercise price is above the book value, it also increases the book value per share.

If the stock price is below the exercise price upon expiry, employees will not exercise the options and will result in the options expiring worthless. When this happens, no new shares are issued and no cash exchange hands.

A well-known company that predominantly uses options as its form of stock-based compensation is Netflix.

Performance stock units

As its name suggests, performance stock units, or PSUs, are converted to shares for an employee based on a company achieving certain performance goals. PSUs are typically only given to senior executives of a company.

Companies that use PSUs tend to combine it with other forms of stock-based compensation.

Employee share purchase plan

Employee share purchase plans, or ESPPs for short, are programs that allow a company’s employees to purchase new shares of the company with a portion of their salary.

So instead of getting all their salary in cash, they receive some in cash and some in shares. Employees are often incentivized to purchase shares using the ESPP as they can buy new shares of a company at a discount to market prices.

However, employees are only allowed to purchase up to a certain amount of shares per year. Companies such as Medtronic offer employees an ESPP if they wish to make use of it.

Like options, this form of dilution is not as bad for shareholders as a company receives cash in return, unlike both RSUs and PSUs.

Round up

The type of SBC that investors need to be most concerned about is usually RSUs and PSUs. These are dilutive to shareholders and companies do not receive cash back in return.

ESPPs are the least concerning as they usually only result in minimal dilution because of the cap that is imposed on how many shares an employee can purchase in a year, and discount that employees get tends to be small.

Options are also not as concerning as long as the exercise price is reasonably high. Most companies issue options that have an exercise price similar to the market price at the point of grant. However, some companies such as Wise issue options that have exercise prices much lower than market prices. In this case, these options are practically like RSUs and shareholders need to monitor the impact closely.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Meta Platforms, Netflix, Wise, and Zoom Video Communications. Holdings are subject to change at any time.

Debunking An Investment Myth

Instead of fretting over stock prices, it is better to focus on how much cash the company can generate and return to shareholders.

There are some investing beliefs that are widely accepted but may not be entirely true. One such belief is the idea that a company has a “common” intrinsic value.

When investors think of investing in stocks, the thought is often that a stock has the same intrinsic value for everyone, and eventually the stock price will gravitate toward that intrinsic value. But this may not be the case.

Intrinsic value is dependent on the circumstances of an investor.

Imagine a stock that consistently and predictably pays out $1 per share in dividends every year for eternity. An investor who seeks to find investments that will give a return of 10% a year will be willing to pay $10 per share. In other words, $10 is the “intrinsic value”. On the other hand, another investor may be highly connected and can find high-return investments that gives him 20% a year. This investor will only pay $5 for the above company. His intrinsic value is thus $5 per share.

As you can see, the intrinsic value for the same share is very different.

Intrinsic value changes with rates

Besides the circumstances of each investor, the intrinsic value of a stock can also change when the risk-free rate changes. If the risk free rate goes up, theoretically, investors will gravitate towards the now higher-yielding bonds. As such, stocks will require a higher rate of return and hence their intrinsic value falls.

As the last couple of years have shown, interest rates can have a very big impact on stock prices.

While all this is happening, the company in question is still the same company.

So despite being the same company, it can have different intrinsic values to different people and may also have different intrinsic values on a day-to-day basis based on the risk-free rate at the time.

So what?

This naturally leads to the question, what price will a stock trade at if its intrinsic value differs from person to person and from day to day?

I believe that it’s impossible to know what price a stock should or would trade at. There are too many factors in play. It depends on the market as a whole and with so many market participants, it is almost impossible to know how the stock will be priced.

Given this, instead of focusing on price, we can focus on the dividends that will be distributed to the investor in the future. This means we do not need to predict price movements and our returns are based on the returns that the company will pay to shareholders. Doing this will ensure we are not beholden to fluctuations in stock prices which are difficult to predict.

What’s more predictable is how a company will perform and whether it can generate cash flows and dividends to the shareholders. As such, I prefer focusing my efforts on looking for types of companies with predictable earnings and paying a price that fits my personal investing returns requirement.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have no vested interest in any company mentioned. Holdings are subject to change at any time.

A Radical Idea To Improve Stock-Based Compensation

Here’s a radical idea to improve stock-based compensation so that employees are inclined to drive long term shareholder value.

The idea of giving stock-based compensation is to turn employees into partners. In theory, giving employees stock will make them part-owners of a business and drive them to think and act like a business owner.

However, the reality is that the way SBC programmes of many companies are designed today actually does not motivate employees to think or act like business owners.

In today’s world, SBC is predominantly given in the form of RSUs or options that vest over three to four years. This means that employees are given a fixed number of shares/options every month over a three to four year period. Although this turns employees into shareholders, it may not adequately motivate them to think like owners of a business.

The reason is that employees can sell the stock as soon as they receive them. Many employees are also not inclined to hold the stock for a long period of time, instead opting to sell the stock when the prices go up. Employees may also consider their contribution to the company as too small to make any difference to the stock price.

As such, this form of SBC does not make employees think like shareholders at all. In fact, I would argue that cash-based compensation would be a better motivator for employees.

Complete lock up

One way that companies try to get around this is to have a lock-up period. In this way, employees are not allowed to sell the shares they receive for a number of years. The lock up period can range from months to years.

But, I think that this is still not enough. Employees need to think like perpetual shareholders where returns are driven by cash flows and ultimately dividends paid to shareholders.

As such, my radical proposal is for SBC to have perpetual lock ups. This means that employees who receive SBC are never allowed to sell unless they are forced to sell via a buyout.

By having perpetual lock ups, employees become true long-term shareholders whose returns are tied to how much cash flow a company is able to return to shareholders.

In this way, employees really think hard about how to maximise cash flow to the company so that the company can pay them a growing stream of dividends in the future instead of just fretting over stock prices. Stock prices are also not entirely in the control of a company as stock prices can also fluctuate based on sentiment and interest rates. Cash flow on the other hand is entirely influenced by management decisions and employee actions.

Although perpetual lock ups may not seem enticing to employees at first, if the company is able to grow and pay dividends in the future, the employee is entitled to a new stream of regular and growing cash income.

Possible push backs

I know there are many possible push backs to this proposal.

For one, some employees may not want to wait so long to receive dividends as an early stage company may take years, if not decades, to start paying dividends. Such a long lock up will not be attractive to employees who want to get rich quick. But that’s the reality of being a long-term shareholder of a business. True business owners are not here to flip the business to someone else but to reap the growing cash flows that the business builds over time. These are patient business builders and that is exactly what we want from employees.

Another pushback would be that it would encourage management to pay dividends instead of investing in other higher return investments. Although this is possible, management who have received shares and are long-term thinkers should be willing to forego some cash dividends today to earn a much larger stream of future cash dividends. Ultimately, a perpetual lock up should drive management to maximise dividend cash flow to themselves over the entire life cycle of the business and not just maximise dividend payment for the near term.

Final words

A perpetual lock-up sounds like a radical idea but it may make employees really think like long-term business partners.

The current model for stock-based compensation via vesting periods and short lock-ups just do not have the same effect in my view. Employees end up focusing on how to drive short term price movements or they just aren’t motivated at all to think like a business owner. In this case, cash incentives and the current form of SBC is not much different.

The only true way to make employees act and think like long-term shareholders is to make them one. And perpetual lock ups probably are the best way to do this.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have no vested interest in any company mentioned. Holdings are subject to change at any time.