Stock-based Compensation, Financial Analysts, and Equity Overvaluation

Stock-based compensation (SBC) is a significant and growing expense for many firms. From fiscal year 2006 to 2018, average SBC has increased steadily from 2.6 percent to 3.8 percent of operating expenses for publicly-traded companies. Despite its importance, however, most firms exclude SBC expense in their non-GAAP earnings, and anecdotal evidence suggests that few analysts consider the expense associated with options in their valuation models. In a recent paper, we investigate whether SBC leads to overvaluation in equity markets and the role played by analysts in the relationship between SBC and valuation.

Ignoring SBC is likely to lead to overvaluation, regardless of whether analysts use earnings-based or cash flow-based valuation models. For earnings-based valuation, SBC can lead to overvaluation as firms are often valued based on projections or multiples of adjusted earnings, which in turn are frequently calculated by adding back the expenses associated with SBC. Even when analysts use discounted cash flow (DCF) models, SBC can lead to overvaluation if the expense associated with SBC is added back as a non-cash expense, along with other non-cash expenses such as depreciation, in the calculation of free cash flows. As the DCF model is based on cash flows and not accrual-based income, it adds back to earnings non-cash expenses like depreciation but subtracts out forecasted capital expenditures, which are the cash-based analog to depreciation expense. However, unlike depreciation, there is no commonly accepted cash flow analog to SBC, so there is no corresponding subtraction as there is for capital expenditures.

But is stock based compensation truly free? The answer is clearly no. Firms will either have to spend cash in repurchasing shares from the open market to reduce the impact of dilution or dilute the ownership of existing shareholders. As a result, if analysts do not account for SBC in their DCF models – either by treating it as akin to a cash expense or, arguably more difficult, accounting for cumulative and future dilution effects of issuing more shares – DCF-based valuations will be inflated.

Motivated by the divergence between the economic reality of SBC as an expense and analysts’ tendency to ignore SBC, we examine whether and how SBC leads to overvaluation. First, we test whether SBC has an impact on firms’ valuation ratios. We find that, as SBC intensity (defined as the ratio of SBC over sales) increases from the bottom to the top quintile within an industry, the average forward price-to-earnings (P/E) ratio increases monotonically from 19.07 to 28.03. We find similar trends for historical P/E, price-to-sales, and price-to-value ratios. We conduct a variety of robustness tests to ensure that these relationships are not explained by the higher growth exhibited by high-SBC firms. These tests all lead to the same inference: SBC is associated with higher market valuations.

To confirm that these higher valuations are indeed overvaluation, we examine ex-post returns over one year. We find that firms in the highest quintile of SBC have the lowest ex-post returns, which are about 5 percent lower than those of firms in the bottom quintile. A risk-based explanation does not explain this pattern, because firms with higher SBC intensity are riskier as indicated by market beta, and thus should earn higher and not lower returns.

Next, we examine the role of analysts in the relationship between SBC and valuation. Notably, we find that the positive associations between SBC intensity and valuation metrics exist only for firms with analyst coverage and become stronger as coverage increases. Further, we find that analysts exclude SBC in their street earnings forecasts and provide more optimistic (and ex post more biased) target prices for firms with high SBC intensity. Specifically, we find that individual analysts’ target prices are 4.4 percentage points more optimistic for firms in the top quintile of SBC intensity than for firms in the bottom quintile (17.8 percent vs. 13.4 percent higher than the current price). Such optimism is not justified by the subsequent realized returns: The target prices of firms in the top quintile of SBC intensity are also on average 4.4 percentage points more optimistically biased than firms in the bottom quintile (mean target price forecast error of -11.4 percent vs. -6.9 percent).

Finally, to show direct evidence that ignoring SBC leads to overvaluation, we hand-collect a sample of 585 analyst reports and focus on whether the inclusion or exclusion of SBC by financial analysts has an impact on their valuation estimates. We read these reports in detail and codify whether analysts include or exclude SBC in their calculation of free cash flows for the DCF model. We find that a majority of analysts (356 reports) ignore SBC as an expense for their valuation models, either by starting their calculation of free cash flows from cash flow from operations, which excludes SBC, or by explicitly adding back SBC in their calculation. However, we also find a significant minority (148 reports) of analysts who do treat SBC as an expense, while the remaining 81 reports are unclear in this regard.

We then compare the ex-post target price bias for analysts that ignore SBC in their DCF models with those who treat is as an expense. We find that the subgroup that excludes SBC has much more optimistic target prices, with target price implied returns of 19 percent that are significantly over-optimistic to the tune of -8.8 percent. Conversely, the subgroup that includes SBC as an expense has lower target prices that are far less likely to be biased, with target price implied returns of 12.7 percent, which actually underestimate actual returns to the tune of 2.2 percent. These inferences remain qualitatively the same if we focus only on firm-years with at least one report that treats SBC as an expense and one that does not, or if we match each report that treats SBC as an expense with a report that ignores it for the same firm at approximately the same time.

To summarize, our results provide strong evidence that the market tends to ignore stock-based compensation as an expense and further that this tendency is associated with overvaluation. These results should be of interest to both practitioners and regulators. For financial analysts, our results indicate that treating SBC as an expense would help reduce their well-documented optimistic bias in valuation. For regulators, who have recently expressed concern about the proliferation of non-GAAP reporting, our paper identifies a specific consequence of misleading non-GAAP reporting: overvaluation.

This post comes to us from professors Partha Mohanram at the University of Toronto’s Rotman School of Management and Brian White and Wuyang Zhao at the University of Texas at Austin’s McCombs School of Business. It is based on their recent paper, “Stock-based Compensation, Financial Analysts, and Equity Overvaluation,” available here.