Airbnb (ABNB -0.41%) is a disruptor. Its innovative app is a favorite with those looking for travel inspiration. And with a market cap of $68 billion, its stock is a favorite for many investors, too.
Yet, Airbnb stock has a hidden drag. It's one that many public companies have and often don't like to talk about: Airbnb utilizes share-based compensation to reward its employees.
There are arguments in favor and against share-based compensation. On the one hand, it aligns employees with shareholders. It gives them a genuine ownership stake in the company. But, unfortunately from an investing perspective, it drives share dilution.
What is share dilution and why does it matter?
Share dilution happens when new shares are created, thus lowering the value of each existing share. Here's a similar real-world example.
Imagine you're having a party, and you agree to order a pizza for your guests. You have eight guests, and you tell them they can each have one slice of pizza. When the pizza arrives, you open the box and see it is cut into eight slices. Perfect! Except, you want some pizza, too. So you decide to cut each slice in half, making 16 new slices of pizza. Since you promised your guests one slice of pizza, you give them each a slice and still have half a pizza for yourself.
Now, this strategy won't win you any friends, because it clearly cuts your guests out of what they thought you were offering: a regular slice of the pie. And that's why investors don't like share dilution either.
When a company creates new shares -- to compensate its employees or reward debt holders -- it undercuts the value of the shares held by the public. In turn, the value of those ordinary shares decreases by the size of the dilution.
Airbnb manages share dilution with its share buyback program
When Airbnb announced a $2 billion share buyback earlier this year, some investors were disappointed. They wanted the company to reinvest in research and development rather than repurchase shares.
However, Airbnb's share repurchase program is playing an important role when it comes to share dilution.
As you can see in the chart above, Airbnb has 633 million common shares outstanding, with an additional 65 million stock-based rewards and warrants outstanding. Since its IPO in December 2020, the company has reduced the size of its stock-based rewards and warrants from 97 million to 65 million -- a reduction of 33%.
Meanwhile, its outstanding common shares have increased by 34 million or about 5%. In effect, Airbnb is using its share buyback program to partially offset the share dilution caused by employees and creditors exercising their stock options. Even better, the company is buying back shares when the stock is near its all-time low.
Airbnb's growing cash balance could support additional share buybacks
Unlike many tech companies, Airbnb is a profitable company that generates plenty of cash. The company has recorded over $2.5 billion in levered free cash flow over the last 12 months. As of Sept. 29, it had over $7.8 billion in cash and equivalents on its balance sheet. That's after having spent $1 billion on share buybacks.
That profitability and cash flow mean that Airbnb will likely continue to invest in its core business and buy back more stock. And those additional share repurchases should minimize the impact of any share dilution.
And that's another reason I'm confident about owning the stock now. Management has signaled that it understands share dilution is a concern, and they've addressed it by using some of Airbnb's cash -- not all or even a majority -- to tamp down the effects of the share dilution. That's intelligent management, and it's another reason why Airbnb is a buy now.