Palantir SBC – Let’s Put This To Bed (NYSE:PLTR)

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PLTR’s Valuation with SBC Analysis

Please click the following link to view the valuation model for Palantir Technologies Inc. (NYSE:PLTR).

PLTR DCF valuation

Including SBC we’ve arrived at a value per share of $25 and excluding SBC we ended up with a $40 value per share – these valuations can be found on the first spreadsheet in the DCF valuation model.

The second spreadsheet is a duplicate of the DCF valuation model but instead we’ve changed the growth and FCF margin projections so that the resulting value per share is close to the current price. We’ve done this to try and gain insight into the market’s projections for PLTR’s revenue growth and FCF margin. And it appears that the market is pricing in growth through FY25 that is notably below management’s 30%+ guidance. Yahoo Finance also shows that the average Wall Street analyst is forecasting 30% and 28% growth for FY22 and FY23, respectively. Indeed, there is a complete lack of confidence in PLTR’s management’s guidance.

We also advise that you go and check out the Options & RSUs spreadsheet for a detailed calculation of their values. The BSM [Black, Scholes, & Merton] may look complicated, but really, it’s just a formula/method for estimating the value of the outstanding options. On the other hand, calculating the value of the outstanding RSUs [Restricted Stock Units] is straightforward – simply the number of unvested RSUs multiplied by the current share price. The values ​​of both the outstanding options and RSUs are subtracted from the EV [which essentially is the present value sum of all the future cash flows] during the reconciliation steps to arrive at the intrinsic equity value – all of which is shown in the DCF valuation model.

Lastly, we suggest you take a look at the Normalized SBC & Operating Profit spreadsheet. There we show that PLTR had adopted a more normalized SBC policy, then their operating profit would have reached the breakeven point in FY21.

Dilution Headwind

From FY20 to FY21 there was considerable dilution. Shares outstanding at the end of FY20 and FY21, respectively, were 1.792 million and 2.027 million, equating to a 13% increase. At the end of 1Q22 the shares outstanding is 2.047 million, a QoQ increase of 1%. However, going forward the dilution will be considerably lower.

It’s quite safe to say the number of outstanding options (both vested and exercisable) will continue to decline. In 1Q21 there were 477m, in 2Q21 there were 417m, in 3Q21 there were 374m, in 4Q21 there were 350m, and in 1Q22 there are now 172m – and in fact there were no new options granted during the whole of FY21, which is really good for because shareholders incentives need to be more heavily tilted toward RSUs/PSUs to better align with shareholders long-term interests. With that in mind, if we say the current 172m options outstanding will convert to an average of 172/7.7 years = 22m shares each year (because the weighted average remaining life of options is 7.7 years), then based on current outstanding share base of 2047m, this represents future annual dilution of 1.1% that is attributable to outstanding options.

From FY20 to FY21 there was a 17% net reduction in unvested and outstanding RSUs. In 1Q22 there was a QoQ 8% reduction.

Unvested and outstanding RSUs

EDGAR

Unvested and outstanding RSUs

EDGAR

As shown above, there are 142m unvested and outstanding RSUs and the notes state that they are expected to be recognized as SBC over the next three years; therefore, 142/3 = 47m shares (on average) will be added to the share base per year over next three years from RSUs. This is another 47/2047 = 2.3% annual dilution.

Add the future annual dilution from options and RSUs and you get an estimate of 3.4% annual dilution – not small but not as bad as many assume.

Thoughts on SBC

SBC & Valuation

Nowadays stock options are less common. They have been almost eliminated from SBC for larger stocks because it has become well-known that they are not a great incentive mechanism to align with shareholders’ [long-term] interests. For newly IPO-ed stocks options do represent a high-ish proportion though this does decline in the subsequent quarters and pretty much phased out as the company matures.

Adding back SBC is an important consideration of future FCFs and hence doing a DCF valuation, but shouldn’t be done if you’re doing a relative valuation with per-share multiples. As mentioned, RSUs form the vast majority of SBC for the majority of firms, and they are only reflected in SBC when they vest and when they vest that means they have been actually handed over to the employees and they have complete discretion to sell – in other words they are in the outstanding share count.

This means the cost of SBC is already reflected in the increased share count and hence reflected in the per-share multiples. Therefore, adding back SBC to calculate a per-share multiple would be double counting the cost of SBC – hence why you shouldn’t add back SBC in doing relative valuations with per-share multiples.

There are some exceptions and that’s why dealing with SBC in valuations can get complicated. 1) If you’re doing a NTM relative per-share multiple valuation it would makes sense to incorporate the dilution in the NTM. To do this, you could simply increase the share count by the TTM increase to estimate the NTM share count. 2) We’re emphasizing per share here because if you’re doing a relative valuation with EV then you’re not viewing the relative multiple valuation with dilution factored in – confusing.

In regards to options outstanding, the expense does need to be added back because they haven’t yet been converted to shares via exercise, even though they may be categorized as vested – more confusion.

When doing a DCF valuation it is different because the unvested RSUs will increase the share count when they vest. To account for this, it is easier to deduct an estimate of SBC as a percent of revenue from the FCF forecasts than it is to mess around with the share count which contains a number of variables [RSU & options vested and exercised, share repurchases, warrant settlements, etc.]. One could just generalize and estimate an overall X % dilution per year, though for companies that recently had their IPO, this is difficult to estimate. The other issue is you’re adding yet another line of estimates to an already subjective model.

However, if you want to get really precise, even doing this results in a little bit of double counting – we estimate a 5% of double counting for PLTR’s case during a 20-year forecast period – because during the EV to equity reconciliation [as shown in the DCF valuation sheet] we deduct the outstanding option and RSU values ​​to reduce the equity value attributable to common shareholders. The reason we say this is double counting 5%is because the combined outstanding value for options and RSUs is currently $1.65bn [which gets deducted in the EV to equity value reconciliation] and in the model, right from FY22 through FY41, we estimate the total SBC for the next 20 years is $36.4bn >>> 1.65/36.4 = 4.5%. And this is because the future RSUs and options [mainly RSUs] have not yet been created, and a lot will be for future employees.

This is getting pedantic, however, because it doesn’t impact the valuation much. Though, perhaps a model amendment should be to start including SBC in the FCF calculation a few years into the future when the current option/RSU value has been converted into shares. Perhaps a weighted average number of years between options and RSUs could be calculated and then the SBC deduction from FCF could start from that point upwards. This would avoid the 4.5% double counting.

PLTR valuation model

Convequity

With this in mind, if we were only forecasting for a 5-year period – which is common for some analysts when conducting a DCF – then the double counting would be much greater. So, this is why it’s not so black-and-white – indeed, we should account for SBC, but how isn’t always obvious.

To summarize, when doing a DCF valuation, one needs to consider the point at which SBC is to be deducted. A) Is it deducted in the form of the outstanding value of the options and RSUs when moving from EV to equity value? B) Or is SBC accounted for by subtracting SBC from the projected FCFs? C) Or is SBC accounted for by estimating future outstanding share counts? For short forecast periods probably one or the other can completely account for the SBC. For longer periods, like the 20-year forecast period for PLTR, we’ve combined A and B (but as aforementioned, not perfectly).

Conclusion

This article has probably confused more than clarified for investors. But it is a tricky area, and in my opinion, working through the confusion is better than just being ignorant to the specificities of accounting for SBC. The easiest way is probably estimating the increase in share count each year, though for a high-growth, recently IPO-ed stock, this is fraught with estimation error more than any other item you would be forecasting – mainly because small errors lead to major changes in the ending value per share.

Anyway, hopefully this article has been useful in some way.

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