How to Answer “How does stock-based compensation affect free cash flow and valuation?” in Investment Banking Interviews

Start with a two-part headline you can reuse across interviews: SBC often increases reported free cash flow in the period because it’s non-cash and added back, but it’s still a real economic cost because it dilutes shareholders or leads to future buybacks.

Then anchor the definition of free cash flow you’re using. In most Investment Banking contexts, interviewers mean unlevered FCF (EBIT(1−T) + non-cash charges − Capex − ΔNWC). SBC reduces EBIT via operating expenses, but then appears as a non-cash add-back in the cash flow reconciliation.

A quick nuance (without derailing): outcomes differ for equity-settled awards (dilution) versus cash-settled awards (future cash payments). You don’t need deep GAAP/IFRS detail—just show you know why the “non-cash” label can be misleading.

Income statement: SBC is typically included in COGS and/or operating expenses, so it reduces operating profit (EBIT) and net income.

Cash flow statement: because SBC is usually non-cash at grant/recognition, it’s added back in the operating cash flow reconciliation, which increases CFO relative to net income. That’s why “free cash flow and stock compensation explained” often starts with the idea that reported FCF can look stronger.

So what’s the right interpretation? In a standard unlevered FCF build, adding back SBC can raise FCF in the forecast period. But economically, that higher FCF is offset by a transfer of value to employees via equity—either more shares outstanding or cash later used to repurchase shares.

In a DCF, you discount unlevered FCF at WACC to get enterprise value, then bridge to equity value and divide by diluted shares. The key point for interviewers: SBC often has a bigger impact on equity value per share than on enterprise value when you treat it as a non-cash add-back.

Two common approaches you can articulate in valuation interview prep:

• Add back SBC in FCF; capture the cost in diluted shares. Options are commonly handled via the treasury stock method; RSUs are often treated closer to one-for-one dilution (subject to vesting expectations).
• Treat SBC as cash-like (or model offsetting buybacks) and keep dilution lower. This can approximate reality when the firm consistently repurchases shares to neutralise SBC-driven dilution.

The rule: don’t double count (subtract SBC from cash flows and also add the same dilution to the share count).

Per-share value is where SBC usually “shows up” most clearly. If SBC is large, diluted shares can grow meaningfully, lowering equity value per share even if your enterprise value is similar.

For multiples, SBC can create comparability issues. EV/EBITDA uses an earnings metric that typically includes SBC expense, so heavier SBC can depress EBITDA and make EV/EBITDA look optically higher versus peers. Some investors discuss “EBITDA excluding SBC,” but you should flag that definitions vary and comparability is the risk.

For terminal value, small changes in assumed dilution or buyback policy can materially affect the per-share output because terminal value often dominates the DCF. A good answer explicitly notes you sanity-check long-run dilution assumptions, not just the next 1–2 years.

Give a simple intuition to show you can reason beyond the accounting: if a company recognises $100 of SBC and you add it back, unlevered FCF is $100 higher today. But if that SBC translates into, say, a 2% higher diluted share count over time (or requires ongoing buybacks), value per share can be lower even though the cash flow line looked better.

Then end with a modelling consistency check an analyst would do: reconcile SBC expense and award disclosures to expected dilution; confirm your diluted share build includes options/RSUs appropriately; and ensure your DCF bridge (EV → equity → shares) matches the method you chose.

That closes the loop on “how does stock-based compensation influence free cash flow” and the valuation implications in one coherent story.