How should you treat stock-based compensation in free cash flow and a DCF?

Accounting treats stock-based compensation as an expense on the income statement, but because no cash leaves the company, it is added back on the cash flow statement. If I simply copy that add-back into a DCF, I am treating employee pay as free, which overstates free cash flow and value, especially for tech companies where SBC can be a large share of revenue.

Economically, SBC is a real cost: the company is paying employees with shares instead of cash, and that dilutes existing shareholders. A company could issue shares to investors for cash and use the cash to pay salaries; the effect on existing owners would be similar.

So I prefer to treat SBC as if it were a cash expense: I do not add it back when calculating unlevered free cash flow. The alternative is to add it back but then increase the share count for all the future grants it implies, which is much harder to estimate. Either way, I pick one approach and avoid double counting, meaning I would not both deduct SBC and dilute for future grants. Existing options and RSUs still go into the diluted share count using the treasury stock method.