Stock-Based Compensation: The Hidden Cost to You

2026-07-13 · By Lubin Danilo, founder of Lubin Investment

Stock-based compensation is when a company pays part of its employees in company shares instead of cash. It barely shows up as an expense reducing reported net income, but it still dilutes existing shareholders, or eats real cash if the company buys back shares to offset it. The gap between companies is huge: for some, it's under 1% of cash generated; for others, more than 40%.

What is stock-based compensation?

Many companies, especially in tech, pay part of their employees' compensation (often engineers and executives) in company stock rather than cash. This is called stock-based compensation, or SBC. The original idea isn't unreasonable: align employee interests with shareholders', since a rising stock directly benefits the employee too.

Why it barely shows up in net income

This is where it gets interesting. Accounting-wise, stock-based compensation is indeed booked as an expense, but it almost never costs the company actual cash at the moment it's granted: the company simply issues new shares (or uses shares it already holds) to pay the employee, rather than cutting a check. The result: reported net income does absorb the accounting charge, but the real cost doesn't show up in cash flow the same way a normal expense would. That's why I always look at actual cash generated (free cash flow) alongside accounting profit.

The real cost: diluting existing shareholders

Every new share created to pay an employee is a smaller slice of the pie for you, the existing shareholder. If the company does nothing to offset it, the total share count rises every year, and your stake in the company (and its future profits) shrinks mechanically, even if the share price doesn't move. Some companies buy back their own shares to offset this dilution and keep the share count flat or falling, but that buyback itself costs real cash. One way or another, stock-based compensation always carries a real cost for shareholders, hidden behind the accounting.

A concrete gap: ServiceNow versus Interactive Brokers

In my screener, I calculate the share of free cash flow that goes to stock-based compensation each year. The gap between companies is striking. At ServiceNow, an enterprise software company, stock-based compensation represents roughly 44% of free cash flow generated over the recent period: nearly half of available cash goes, one way or another, to employee stock. At Interactive Brokers, the online broker, that figure drops to roughly 0.7%, next to nothing. Two highly profitable companies, but more than a 60-fold gap between them on this single criterion.

Why does this gap exist?

The industry explains most of the gap. Software companies must attract and retain highly sought-after engineers in a competitive labor market, and stock has become the standard compensation tool across all of Silicon Valley: refusing to grant it would mean losing the talent race. Financial companies like Interactive Brokers, more automated and less dependent on a large engineering headcount, structurally need this lever far less.

How I use this criterion in my method

A high level of stock-based compensation isn't automatically disqualifying, especially if the company is growing fast and genuinely needs that talent to do it. But I use it as a reality check on the true benefit to shareholders: a company showing nice cash-per-share growth while handing out 40% of that cash in new shares is actually telling a less generous story than the raw number suggests. I always prefer looking at free cash flow growth PER SHARE (which accounts for this dilution) rather than total free cash flow growth.

Stock-based compensation means paying part of salaries in shares instead of cash: it barely shows up as a cash expense
The real cost to you as a shareholder is dilution: more shares outstanding, a smaller slice of the pie per existing share
Real measured gap: roughly 44% of free cash flow at ServiceNow versus roughly 0.7% at Interactive Brokers
The tech sector structurally relies far more on this lever to attract engineers; finance far less so
I always look at free cash flow growth PER SHARE, which accounts for this dilution, rather than total cash growth

FAQ

Is stock-based compensation a bad thing by itself?

Not necessarily. Aligning employees with stock performance makes sense, especially at fast-growing companies that need to attract scarce talent. The problem shows up when the level becomes disproportionate to actual cash generated.

Why doesn't net income reflect this cost well?

The accounting charge does exist on the income statement, but it doesn't match a real cash outflow at the time of granting (the company issues shares rather than paying cash). The real cost mainly shows up in share count dilution, not in net income itself.

How do you know if a company is offsetting its dilution?

By looking at the total share count trend over several years. If that number falls despite high stock-based compensation, the company is buying back enough shares to offset it. If it rises, the dilution isn't being offset.

Is this criterion alone enough to rule out a stock?

No, I always combine it with free cash flow growth per share and my other quality criteria. High stock-based compensation at a fast-growing company can still be a good investment, as long as you're aware of it.

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About the author

Written by Lubin Danilo, founder of Lubin Investment. A self-taught individual investor, I find fundamental analysis fascinating, and it has delivered excellent results. For three years now, my performance has beaten the S&P 500. But analyzing every stock took too much time: sites with incomplete data, calculation methods and criteria never aligned with mine. And spotting the best stocks was just as time-consuming, even with my own well-defined checklist. So I put my software development background to work to build this software, base my investment strategy on its results, and share it with people who share the same passion as me. It judges a company's quality and its price separately, using criteria drawn from the financial literature (Warren Buffett, Michael Mauboussin, Aswath Damodaran).