You've probably seen the headlines. A massive tech giant reports billions in profit, yet their "adjusted" earnings look way better than the numbers they filed with the SEC. Why the gap? Honestly, it usually comes down to one thing: stock-based compensation (SBC).
It’s a weird kind of magic. Companies pay employees with shares instead of cash, which feels like "free" money because no actual cash leaves the bank account today. But for the accounting world—and specifically under the rules of ASC 718—that "free" pay has a very real, very heavy price tag on the income statement.
Basically, if you give someone a piece of the company, that is an expense. Period. Even if it's just a promise of future shares, the law says you have to tell investors exactly what those promises are costing the business.
How Equity-Based Compensation Impacts Reported Earnings Every Single Quarter
The most direct way equity-based compensation impacts reported earnings is through the compensation expense line on the income statement. Back in the early 2000s, companies didn't really have to "expense" stock options. It was a wild west era. But after some massive scandals (looking at you, Enron), the Financial Accounting Standards Board (FASB) stepped in.
Now, whether you’re giving out Restricted Stock Units (RSUs) or classic stock options, you have to estimate their "fair value" on the day you grant them.
The Grant Date Trap
Imagine a startup grants 10,000 options to a new engineer. The stock isn't even public yet. The company has to use complex math—usually something called the Black-Scholes model—to guess what those options are worth today. Once they have that number, say $100,000, they don't just deduct it all at once.
They spread it out over the "vesting period." If the engineer has to stay for four years to get all the shares, the company recognizes $25,000 in expense every year. This happens regardless of whether the stock price goes to the moon or crashes into the basement. This creates a fixed drag on reported earnings that can't be easily turned off if the business hits a rough patch.
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The Invisible Drain on Earnings Per Share (EPS)
If the expense on the income statement wasn't enough, equity pay attacks your "per share" numbers from a second angle: dilution.
You've got a pizza. It’s cut into 10 slices. If you suddenly decide to cut it into 12 slices so you can give two to your employees, the original people holding the 10 slices now have less pizza per slice. This is exactly what happens with Diluted Earnings Per Share.
Basic vs. Diluted EPS
- Basic EPS only counts the shares that are actually out there right now.
- Diluted EPS is the scary one. It assumes all those options and RSUs will eventually become real shares.
When a company issues more equity to employees, the denominator of the EPS equation grows. Even if the company’s net income stays exactly the same, the reported earnings per share will drop because that income is being spread across more "owners."
For heavy users of SBC, like Palantir or Salesforce, the difference between "Basic" and "Diluted" shares can be massive—sometimes a 10% to 20% swing in what you actually "own" as a shareholder.
Why Companies Love to Hide It in "Non-GAAP" Numbers
If you read an earnings release, you’ll see "Non-GAAP" or "Adjusted" earnings. Companies almost always add back the stock-based compensation expense to these numbers. They’ll tell you, "Hey, this isn't a cash expense, so it doesn't represent our true operating performance."
Don't be fooled.
While it's true that SBC doesn't drain the bank account today, it is a real cost of doing business. If you didn't pay those engineers in stock, you'd have to pay them in cash. By pretending the stock expense doesn't exist, companies can make their profit margins look 20% or 30% higher than they actually are.
Investors in 2026 are getting smarter about this. They’re starting to look at Free Cash Flow per Share instead of just "Adjusted EBITDA" because it forces the company to account for the creeping share count.
The Tax Side: A Rare Silver Lining?
It isn't all bad news for the reported numbers. There is a weird tax quirk that can actually boost earnings.
When an employee's RSUs vest or they exercise options, and the stock price has gone up significantly since the grant date, the company gets a tax deduction for that "gain." In a bull market, this tax benefit can sometimes lower the company’s effective tax rate so much that it offsets a chunk of the compensation expense.
But keep in mind: this only works when the stock price is rising. In a flat or declining market, that tax "windfall" disappears, leaving the company with a massive expense and no tax shield to hide behind.
Practical Steps for Evaluating a Company's SBC Impact
If you're looking at a company's financials and want to see the real damage, do these three things:
- Check the Statement of Cash Flows: Look for the line item "Stock-based compensation." See what percentage it is of the total "Net Cash Provided by Operating Activities." If it's more than 25%, the company is essentially "paying" for its operations by diluting you.
- Compare GAAP vs. Non-GAAP Margins: If the GAAP operating margin is -5% but the Non-GAAP margin is +15%, and the only difference is SBC, that company isn't actually profitable. It's just shifting the cost to future shareholders.
- Watch the Share Count Trend: Look at the "Weighted Average Shares Outstanding" over the last three years. If it’s growing every year despite the company buying back stock, they are running on a treadmill just to stay in place.
Equity-based compensation is a powerful tool for startups and tech giants to attract talent without burning cash. But for you, the investor, it’s a silent tax. It reduces the reported earnings you see on the front page and shrinks your slice of the pie over time. Understanding that "non-cash" doesn't mean "no cost" is the first step to truly reading a balance sheet.