You know SBC's mechanics already: expensed in the P&L at grant-date fair value, added back in CFO as non-cash, settled in shares. The analytical consequence is large and widely gamed. CFO, and therefore FCF, is computed as if employee equity comp were free. The company paid a real cost. It just paid in shares instead of rupees, so the cash statements never see it. The cost lands on owners as dilution: the same future cash flows, sliced across more shares.
Why does this matter at scale? For mature Indian companies SBC is usually noise, under 1 to 2% of revenue. For US tech it's structural. Mega-caps run ~3 to 8% of revenue, and young SaaS companies run 15 to 40%. Picture a software firm reporting a "25% FCF margin" while granting SBC worth 30% of revenue. It isn't free-cash-flow positive in any sense an owner should care about. It's paying its wage bill with your ownership percentage.
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How do you adjust free cash flow for stock-based compensation?
There are two fair corrections. Pick one and use it consistently.
Fix A: treat SBC as the cash cost it economically is:
Owner FCF = FCF − SBC expenseThe rationale: to keep shareholders whole, the company would have to buy back the very shares it grants, spending roughly the SBC value in cash. It's simple and conservative. It's also slightly rough, since grant-date value ≠ eventual dilution cost. And it's the right default for screening.
Fix B keeps FCF and does all per-share math on a growing share count. Project the dilution, using the share count CAGR from the last 3 to 5 years net of real buybacks, and compute FCF per share. A company growing FCF 20% with 4% annual dilution is compounding owner value at ~16%. The headline overstates the owner's return by a fifth, forever. Worked Example 2 shows that arithmetic biting a realistic SaaS case.
Do buybacks offset stock-based compensation?
And retire one fallacy for good. "We buy back stock to offset dilution" doesn't return capital. Spending ₹100 crore of FCF to repurchase the shares just granted to employees is paying compensation in arrears, and the FCF was never free. When you build the cash walk, count buybacks up to the SBC value as a compensation cost, and only the excess as a real distribution. Damodaran's and Mauboussin's pieces in the reading list both formalize this. The reflex matters more than the formalism.