Nvidia has breathed new life into a hotly debated topic on Wall Street: paying executives in stock and how it impacts investors' ownership positions in companies. The AI powerhouse updated its methods alongside its recent quarterly results . With so many other important discussion points involving the world's most valuable company, accounting for stock-based compensation (SBC) was largely overlooked at the time. But it matters because it does, ultimately, impact earnings. And, we believe as fundamental investors that earnings drive stock prices. Here's what CFO Colette Kress said on Nvidia's post-earnings conference call on Feb. 25: "Starting this quarter, we will be including stock-based compensation expense in our non-GAAP results. Stock-based compensation is a foundational component of our compensation program to attract and retain world-class talent." — Kress That may seem like some kind of bean-counter minutiae. But legendary investor Warren Buffett has long criticized the practice of not including SBC. In his 2018 letter to Berkshire Hathaway shareholders, Buffett wrote: "Managements sometimes assert that their company's stock-based compensation shouldn't be counted as an expense. (What else could it be – a gift from shareholders?)" — Buffett Before we dive into this, let's briefly explain the difference between GAAP and non-GAAP earnings, which we covered extensively last fall ; it's worth a read if you haven't already. A quick summary here: GAAP is short for generally accepted accounting principles. A not-for-profit group called the Financial Accounting Standards Board (FASB) issues the standards, and public companies in the U.S. need to adhere to GAAP rules when submitting their financial statements to the Securities and Exchange Commission. Non-GAAP, or "adjusted," results include any and all reported metrics that do not adhere to those principles. Management teams often provide these additional results on the belief that they provide a better understanding of the company's fundamentals than some GAAP metrics. For example, management teams will often "adjust out" one-time items or foreign exchange dynamics to provide a better understanding of the trajectory of the business on an apples-to-apples basis versus prior periods. There's nothing inherently wrong with reporting non-GAAP figures alongside GAAP. It's those adjusted numbers that many on Wall Street judge the results. This brings us back to stock-based compensation (SBC), which is another common thing that gets adjusted out. However, this tends to be a more controversial adjustment than one-time items like legal fees or regulatory fines, and currency fluctuations. A closer look at the dynamics of SBC will illustrate why some investors take issue with its exclusion when calculating non-GAAP results. As the name implies, stock-based compensation is when companies pay employees in stock, rather than cash. This has a few implications for each of the three financial statements that together represent the financial health of a company: the income statement , the cash flow statement , and the balance sheet . Let's take them one by one. Impact on the income statement The income statement summarizes a company's revenue and expenses over a period of time, like a quarter or a full fiscal year. The impact of SBC is visible when comparing GAAP and non-GAAP numbers once we move below the revenue line and see its operating expenses — such as overhead, known as selling, general and administrative (SG & A), and investments in new products, known as research and development (R & D). On Wall Street today, many companies include adjusted earnings per share (EPS) when they report financial results, contending it provides investors a clearer picture of the underlying fundamentals than a GAAP figure weighed down by, say, restructuring costs from closing a big office or layoffs. According to GAAP guidelines, SBC is required to be reported as an expense — it could be considered SG & A or R & D depending on the employee's job — so it will reduce net income. Nevertheless, many management teams remove equity compensation from non-GAAP results, arguing that because it's not a cash outlay, it shouldn't count against the net income result. However, that fails to account for the dilutive impact of SBC, which we see when looking at the balance sheet — more on that in a second. When Nvidia reported fourth-quarter results, it provided the numbers using its old approach , along with a restatement to show the impact including stock-based compensation would have had on its adjusted EPS figure. Take a look at the graphic below. On the left in red, we see the results without SBC. On the right side of the adjusted income statement above, in light blue, we see what it'll look like with SBC going forward. The key thing to note is that the GAAP results stay the same, so the starting point doesn't change; however, the non-GAAP results all move lower to reflect the SBC added back into calculating the new adjusted results. Crucially, we see on the right that adjusted EPS would've been $1.59 in the fourth quarter, instead of the $1.62 reported. Balance sheet impact The balance sheet is where we find assets, liabilities, and equity, which is assets less liabilities. It is also where the number of shares outstanding is recorded. Earnings per share (EPS) is net income (the numerator) divided by shares outstanding (the denominator). EPS is also what we use to value most companies. If a company is experiencing declining EPS, it could be because its net income is declining alongside a steady share count. Another possibility is that the number of shares outstanding is increasing at a faster rate than net income. When a company issues shares to pay for salaries instead of giving employees cash, its share count increases. So, when EPS declines as a function of a higher share count, that is the definition of dilution. You, the shareholder, now have a smaller claim to the company's net income than you did before. The takeaway: Many investors may be fine with grading companies on an ex-SBC basis because it's not realized as a cash outlay. But there's no free lunch. The cost of the SBC will ultimately be reflected in a company's financial results via that larger share count. There's only one way to offset the dilutive nature of SBC — stock buyback programs — and there's plenty of important considerations here, too. When a company decides to use its cash to repurchase shares, that is an investment in its own right. Would that money produce a greater return if it were invested in organic growth initiatives or used on acquisitions that grow revenues and, presumably, profits? Might it be better to return some of the cash to investors with a dividend instead? Stock buybacks can be a great use of capital, but it's worth remembering that the money could be spent on other things that benefit shareholders, too. On this note, the absolute dollar amount of the buyback doesn't tell you how many shares are being pulled out of the market — or, in other words, how much cash is actually being returned to shareholders. To truly understand the impact of a buyback program, investors need to look at both stock-based compensation levels and the number of repurchased shares. The net effect of both is what matters to your claim on net profits. If more shares are being bought back than are being issued in SBC, leading to a reduction in the share count, that is anti-dilutive. If the total share count continues to increase because the company is issuing more stock to employees than it's repurchasing, it's still dilutive. Of course, some investors may appreciate that the buyback is, at least, moderating the dilution from what it otherwise would be. The best buybacks are those that lower the share count. With fewer shares outstanding, EPS increases, even if total profits remain the same. For that reason, a buyback can ultimately drive shares higher over time, even without topline growth or an expansion of margins. Indeed, dilution tends not to be a back-breaker for investors so long as EPS continues to grow at attractive levels. In other words, they're willing to accept the dilution because EPS is still growing at a respectable enough clip, even with the dilution factored in. Cash flow impact Arguably, the biggest point of contention on stock-based compensation is found on the cash flow statement. While sometimes overlooked, the cash flow statement is a key indicator of a company's financial health because it helps explain the real strength — or weakness — of a company's earnings. Profits backed by cold, hard cash are the most desirable. Cash flow statements have three sections: operating, investing, and financing. Our focus here is on the operating side, which deals with a company's ability to generate cash internally. As mentioned, stock-based compensation does not represent a cash outflow. For that reason, salaries paid with SBC are added back to the net income figure when calculating operating cash flows. The implications? A cash-paid salary would not be added back, but one paid in SBC increases the operating cash flows a company reports. You can see that dynamic illustrated below in Nvidia's fourth-quarter and full-year statement of cash flows. Highlighted in blue below is the stock-based comp being added to the net income figure. As we move further down the list, we see the various non-cash items that get subtracted in parenthesis such as inventories and prepaid expenses. To be sure, adding stock-based comp back is the right move since SBC is indeed not a cash inflow nor outflow; however, what that means is that the cash flow profile is being skewed by employees' willingness to accept payment in stock. If the stock becomes less desirable to employees — say, its growth prospects are dimming — and the company increasingly needs to pay a larger percentage of compensation in cash, the adjustment to net income will get smaller. All else equal, that could mean its operating cash flows look a bit less impressive. Many argue that SBC artificially inflates operating cash flows. So what? Consider that most companies define free cash flow (FCF) as operating cash flow minus capital expenditures — and free cash flow is an important measure of financial health in modern finance. In fact, for some investors, FCF is the gold standard. Well, if operating cash flow is the starting point to calculate free cash flow, then any inflation to operating cash flows also inflates free cash flow. So again, as is the case with operating cash flow, free cash flow is tied to employees' willingness to be paid in stock. And their willingness to accept it is tied to their perception of the stock they're getting paid in. Why it matters When things are going well, investors tend to look past stock-based compensation. "Sure, I'm getting diluted, but the earnings are growing fast enough to offset it, so I'm still making money," an investor might say to themselves. "Cash flows are being boosted so the company's balance sheet looks better," they might also say. "Plus, the rest of Wall Street is valuing the company on non-GAAP results, which exclude the dilution." The result: We get rewarded for the positives, and we just adjust out the negatives. Pretty nice situation, if you can maintain it. However, there's a problem with this thinking. No individual investor gets to determine whether the rest of the market agrees to maintain it. Things can turn, just like we saw to start the year with software stocks, which are heavy issuers of stock-based compensation. When sentiment starts to shift on a group of stocks, the goldilocks thinking around SBC runs into some issues. For starters, companies can't just declare, "We're paying employees in stock." Those employees have to be willing to accept that form of payment as part of their total compensation package. When a stock is ripping, and everyone thinks the party will go on, they're more than happy to accept equity as part of their pay. However, when the stock isn't looking so great, folks start to remember that 1) you can't pay your bills in stock and 2) SBC often comes with material vesting periods, meaning you can't get all your stock on Day One and sell it for cash; it trickles in over time, so what it will ultimately be worth by the time it's yours to sell is dynamic. Granted, it may not be common for companies to materially adjust the total comp packages and start paying everyone in 100% cash, instead of, say, 80% cash and 20% equity. But the dynamic is still worth noting because it could pose issues for contract renegotiations or hiring incentives, something Nvidia highlighted when noting the change to its non-GAAP adjustments. So, what happens to a company's financial statement if it runs into trouble and the employees no longer want to be paid in stock, instead demanding more of their salaries be paid in cash? For starters, there is less for companies to adjust out of their GAAP results, so the benefit to non-GAAP earnings declines. Issuing less equity will help with dilution, but the adjusted earnings figure that most investors grade stocks on will take a hit. At the same time, salaries paid in cash do represent cash outflows, so cash on the balance sheet takes a hit, and suddenly the company's cash flow profile changes. Whereas operating and, in turn, free cash flow results were previously boosted thanks to SBC, investors are now looking at new, less attractive cash flow results. Don't forget, less cash on hand also means a reduced ability to buy back shares. It's for these reasons that some investors will take the results companies that rely heavily on SBC report, and adjust for the impact by treating any SBC as a cash expense and adjusting the financial statements accordingly to better understand what the company looks like without the practice of paying employees in SBC, which again, is really only an attractive option when things are going well, earnings are growing faster than the rate of dilutions and employees are all too happy to be paid in stock. Our Club view Now, back to what Nvidia's Kress told us last month and what it means for us. Simply put, we like the decision. In general, the closer a company gets to focusing on GAAP numbers — we say focusing on because all US-listed companies must legally report GAAP results, but they can steer investors and analysts to adjusted figures — the better. That said, we also understand that to truly understand and gauge some modern business models, some non-GAAP metrics are important to monitor, such as annual recurring revenue (ARR) or remaining performance obligations (RPO). At the same time, some items do make sense to adjust for, like when they cloud the actual operating results. In fact, even those companies, like the mega caps that focus almost entirely on GAAP results will occasionally adjust for large one-time expenses, like legal fees. For example, in its third-quarter results in October , Club name Amazon called out two special charges — a settlement payment with U.S. regulators and severance costs — that dented operating income by $4.3 billion in the quarter. Amazon is usually a strident GAAP reporter. In this case, we think that's fair to look past, given they really don't have anything to do with the ongoing operations of the business, and as a result, did serve to cloud the true performance of ongoing operations in the quarter. Stock-based compensation, however, is one of those things that we do think can become more problematic when attitudes toward the stock change — even if those attitudes are sometimes souring when the underlying fundamentals suggest they shouldn't. As a result, we appreciate Nvidia's decision to reflect the impact of SBC in non-GAAP results, as it gets us a bit closer to the true understanding of the cost to run the world's most valuable company. This will lower Nvidia's adjusted EPS figure slightly, which means that all else equal, its price-to-earnings ratio will tick up a bit. But it's a small change — going from $1.62 to $1.59 in the fourth quarter is less than 2%. Had the new policy been in place, its year-over-year EPS growth rate would've dropped to 78.7% from $82. That's still remarkable growth for a company at Nvidia's size and the stock continues to trade at a cheap valuation of roughly 22 times forward earnings, according to FactSet. Importantly, this change will need to be considered when comparing Nvidia's stock valuation to its peers. You always want to ensure that valuation comparisons are as apples-to-apples as possible. That means adjustments should generally be uniform one company to the next, and if they are not, it's on the investor to address that accordingly. For example, Nvidia rival AMD continues to adjust out SBC from its adjusted EPS figure. Kress is right that stock-based compensation is crucial for a great company to leverage in attracting and retaining world-class talent. We're certainly not arguing against it. Giving employees more skin in the game aligns incentives across C-suite management, who typically receive a larger chunk of their pay in stock; the rank-and-file employees who keep the business running on a day-to-day basis; and the investors. At the same time, it's equally crucial that investors understand the impact this form of payment has on financial results. With Nvidia's change, in particular, the impact should only show up in the income statement, where we find operating income, net income and earnings per share. The cash flow statement and balance sheet still must reflect actual cash flows recorded in the quarter, so nothing should be different in future quarters. The bottom line? Nvidia will still be able to use its stock as currency to attract and retain the best talent in the world, and investors get more transparency. That looks like a win for everybody involved. (See here for a full list of the stocks in Jim Cramer's Charitable Trust.) 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