SBC: how invisible dilution erodes your stock returns
2026-06-23 · By Lubin Danilo, founder of Lubin Investment
SBC (Stock-Based Compensation) is the remuneration of executives and employees in shares or options. It is a real charge for the shareholder because it dilutes their share of capital, but it does not appear in operating free cash flow. Our method requires an SBC/FCF ratio below 10%. Beyond that, the company distributes an excessive fraction of its created value to its employees rather than to its shareholders.
What is SBC and why does it matter?
Stock-Based Compensation (SBC) is the portion of executive and employee compensation paid in the form of shares (stock awards) or stock purchase options. Unlike cash salaries, SBC does not immediately leave the treasury — it creates or grants new shares, which dilutes existing shareholders. In GAAP accounts, SBC is recorded as an operating expense that reduces net income. But in the cash flow statement, it is added back into operating cash flows because it is "non-cash." Result: apparent operating free cash flow includes SBC. Our method removes it to measure the true FCF available to shareholders.
The concrete impact on your investment
Take a simple example: a company generates $100M in apparent FCF. It distributes $40M in SBC to its executives and employees (new shares created). The existing shareholder only receives $60M of value — the remaining $40M goes to employees via dilution. If you own 1% of the capital, your effective share of FCF is $600K, not $1M. The dilution is gradual, invisible in a single year, but massive over ten years. A company with 30% SBC/FCF over ten years may have cumulatively diluted its shareholders by 30%.
Real examples in our screener
| Company | Estimated SBC/FCF | Our assessment | Impact |
|---|---|---|---|
| Mastercard (MA) | <3% | Excellent | Near-zero dilution |
| NVIDIA (NVDA) | ~8% | Acceptable | Within our limit |
| ServiceNow (NOW) | ~12% | Slight tension | Above our threshold |
| Shopify (SHOP) | >30% (historical) | Problematic | Massive past dilution |
| Mature big tech (MSFT, AAPL) | 5-10% | Acceptable | Offset by buybacks |
Our criterion: SBC/FCF < 10%
Our screener applies an SBC/FCF criterion below 10%. This threshold means that less than 10% of generated free cash flow is redistributed to employees via shareholder dilution. This criterion is particularly discriminating in the tech sector where SBC is cultural: some software companies distribute 20%, 30%, even 40% of their FCF in stock options. For a long-term shareholder, this is an invisible but real levy. Companies that pass this criterion are those that reward their executives in shares BUT offset this dilution via aggressive share buybacks — thus keeping the share count constant or declining.
How to identify SBC in company accounts
SBC is always visible in two places in financial statements. In the income statement: look for the "stock-based compensation expense" line in operating expenses. In the cash flow statement: it appears as an add-back in operating cash flows (line "stock-based compensation" with a positive amount added to cash flows). To calculate SBC-adjusted FCF: operating FCF minus SBC. Compare this figure to market cap to obtain a more conservative FCF multiple that is truer to shareholder reality.
FAQ
Does high SBC mean the company is poorly managed?
Not necessarily. In the tech sector, SBC is standard practice to attract and retain talent in a very competitive job market. The problem is not SBC itself, but its level relative to FCF and the compensation discipline via buybacks. Mastercard pays very little in SBC and aggressively buys back shares. Shopify has historically paid a lot in SBC without sufficiently compensating. The difference is structural.
Do share buybacks truly neutralize SBC dilution?
Yes, if buybacks are greater than or equal to the dilution created by SBC. A company that creates 5M new shares via SBC but repurchases 7M over the same period reduces its total share count — favorable for shareholders. A company that creates 10M new shares via SBC but only repurchases 3M net-dilutes shareholders. This is why our screener evaluates net buybacks (buybacks minus SBC) not gross buybacks.
Why does apparent FCF overvalue companies with heavy SBC?
Because in the GAAP cash flow statement, SBC is added back as a non-cash charge in operating cash flows. Result: operating FCF includes SBC, artificially inflating it. An investor calculating a price/FCF multiple without removing SBC pays an apparently more favorable multiple than reality justifies. This is a systematic bias that favors high-SBC tech companies in gross multiple comparisons.
What is the acceptable SBC level for different sectors?
Acceptable SBC/FCF varies by sector. In traditional industrial and financial sectors, SBC is generally below 5% — these sectors compensate more in cash. In SaaS and tech, our 10% threshold is already selective: the average is around 15-20%. In biotechs, SBC can be enormous (50%+) because executives are compensated with options in a company with no revenues. Our criteria exclude most biotechs for this reason.
How to tell if a company truly offsets its SBC dilution?
Look at the evolution of diluted shares outstanding over 5-10 years. If the share count falls despite active SBC, buybacks are offsetting dilution. If the share count stays flat, SBC and buybacks balance out. If the share count steadily increases, the company is diluting shareholders despite buybacks. Mastercard shows a ~3% annual share reduction. Shopify increased its share count by +60% over five years.
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About the author
Written by Lubin Danilo, founder of Lubin Investment. A self-taught individual investor, I have analyzed stocks through their fundamentals for several years and invest my own money with this method. I codified it into a tool that judges a company's quality and its price separately, using criteria drawn from the financial literature (Warren Buffett, Michael Mauboussin, Aswath Damodaran).