Stock-based compensation, financial analysts, and equity overvaluation
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Stock-based compensation, financial analysts, and equity overvaluation Partha Mohanram 1
& Brian
White 2 & Wuyang Zhao 2
# Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract Stock-based compensation (SBC) reduces the value of shareholder equity, ceteris paribus, and is a significant and growing expense for many firms. Despite its valuation implications and its growing importance, anecdotal evidence suggests that market participants ignore SBC in valuation. We first find that firms with higher SBC exhibit both higher valuation ratios and lower returns, suggesting overvaluation. This pattern is stronger for firms with larger analyst coverage, implying that the sell-side optimism is an important driver of the overvaluation. We then examine how financial analysts treat SBC in their valuation models. We find that analysts exclude more expenses in their street earnings forecasts and provide more optimistically biased target prices for firms with higher SBC. A hand-collected sample of analyst reports indicates that analysts who ignore SBC in valuation derive optimistically biased price targets, whereas analysts who treat SBC as an expense are unbiased on average. Together, our evidence indicates that market participants’ failure to account for stock-based compensation as an expense leads to the overvaluation of equity. Keywords Stock-based compensation . Financial analysts . Overvaluation . Non-GAAP .
Free cash flow . Discounted cash flow (DCF)
JEL classification G10 . G14 . M4 . M41
* Partha Mohanram [email protected] Brian White [email protected] Wuyang Zhao [email protected]
1
Rotman School of Management, University of Toronto, Toronto, Canada
2
McCombs School of Business, University of Texas at Austin, Austin, TX, USA
P. Mohanram et al.
1 Introduction Stock-based compensation (henceforth SBC) is a significant and growing expense for many firms. From fiscal year 2006 to 2018, mean (median) SBC as a percentage of operating expense has increased almost monotonically year over year from 2.6% to 3.8% (0.8% to 1.4%) in the universe of firms on Compustat and CRSP. Despite its importance, however, many firms and market participants appear to ignore the expense associated with SBC. For example, Barth et al. (2012) show that most firms exclude SBC expense in their non-GAAP earnings. Black et al. (2018) find that SBC-related exclusions in non-GAAP EPS more than doubled from $0.31 per share in 2009 to $0.64 per share in 2014. Furthermore, anecdotal evidence indicates that very few analysts consider the expense associated with options in their valuation models, suggesting that analysts mimic firm managers’ practice of ignoring SBC (Mauboussin 2006; Lundholm and Sloan 2017, p. 238). In this paper, we investigate whether SBC leads to overvaluation in equity markets and the role played by analysts in the relationship between SBC and valuation. Excluding SBC expense can potentially lead to overvaluation, regardless of whether analysts use earnings-based
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