In my article “Understanding The Bull Case For Salesforce.com,“ I have already approached the problem that a lot of Salesforce.com’s (NYSE:CRM) operating cash flow comes from paying compensation in stock (trending toward 40%-50% in 2011). This is far from being unique to Salesforce.com, but seems to confuse a lot of people – analysts included – who easily handle such cash flow the same way as any other cash flow.
Some go as far as saying that the dilution from such a practice is already stated in the P&L statement, so if one was to exclude the cash or consider the costs, one should not consider the dilution because that would be double-counting.
In this article I will show that such a cash flow really isn’t the same as regular cash flow from operating activities.
I will do this by showing what would happen to a company that generated cash over a 50-year period, and distributed it equally to the shareholders at the end of that period, under various scenarios.
Company A generates cash flow from operations while paying its employees in cash
We will consider this company to accrete $500 in cash per year, and the company will start with 100 shares and not dilute them.
What we see here, is that at the end of the period, the company accumulates $25000 in cash and distributes $250 cash per share.
Company B generates cash flow from operations while paying part of the employees’ compensation in share-based compensation
We will consider this company to accrete $500 in cash per year, but $250 of the $500 will come from compensating employees using share-based compensation, leading to 2% share dilution per year.
What do we observe? That at the end of the period, the company has accumulated the same amount of cash as company A, $25000, however, because of the dilution each share is entitled to just $92.88 cash per share.
Company C generates half the cash flow from operations while paying employees in cash
We will consider this company to accrete just $250 in cash per year, and the company will start with 100 shares and not dilute them. So this company will be producing cash at HALF the rate of company A or B.
What happens after 50 years? The company has accumulated $12500 in cash, and will distribute $125 per share. This is actually incredible; the company distributes MORE cash per share, and is thus more valuable, than company B!
Cash from operations that is a result from share-based compensation is worse than cash that isn’t generated at all. I usually say we should ignore such cash and remove it from operating cash flow, but what we can see here is that given the implied dilution from generating cash this way, this is actually more grievous than not generating it at all, and not having the dilution.
So, when people go around calculating Salesforce.com’s or other techs’ earnings and cash flow INCLUDING the part that comes from using share-based compensation, they would do well to ignore the component of cash flow that arises from that practice, if they plan to use the present number of diluted shares in any calculation. And they should also bear in mind that even doing so is not conservative at all, because this cash carries with it a value of less than zero for present shareholders, given the dilution it implies over the long term.
The value of a company is extraordinarily tied to the dilution it undergoes. If we had run the experiment above with 5% dilution per year, the cash per share distributed at the end of the period would have been $21.8, a full 11.4 times less than the scenario without dilution, and 5.7 times less than the company with half the cash flow. The value of a company that dilutes trends rapidly toward zero with the increase in dilution.
Disclosure: I am short CRM.