Should stock-based compensation (SBC) be added back when calculating free cash flow?

When calculating free cash flow, stock-based compensation (SBC) is treated as a non-cash expense. This means that it does not involve an actual cash outflow at the time it is recognized. Instead, it is an accounting expense reflecting the cost of compensating employees with stock options or shares.

Because SBC is non-cash, it is added back when calculating free cash flow. This adjustment provides a clearer picture of the company’s cash-generating ability, as it shows the actual cash available to investors without the distortion of non-cash accounting items. Treating SBC as a cash expense overlooks the nature of the expense and could lead to an inaccurate estimation of a company’s cash flow and financial health.

By understanding why SBC is added back, one can appreciate the nuances in financial modeling, particularly in discounted cash flow analysis, where accurate cash flow projections are crucial for valuation.