Stock-based Compensation, Financial Analysts, and Equity Overvaluation

55 Pages Posted: 21 Aug 2019

See all articles by Partha S. Mohanram

Partha S. Mohanram

University of Toronto - Rotman School of Management

Brian J. White

University of Texas at Austin - Department of Accounting

Wuyang Zhao

University of Texas at Austin - Department of Accounting

Date Written: November 15, 2019

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. In particular, such pattern becomes 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 SBC 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: G14; M41

Suggested Citation

Mohanram, Partha S. and White, Brian J. and Zhao, Wuyang, Stock-based Compensation, Financial Analysts, and Equity Overvaluation (November 15, 2019). Available at SSRN: https://ssrn.com/abstract=3439089 or http://dx.doi.org/10.2139/ssrn.3439089

Partha S. Mohanram

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Brian J. White

University of Texas at Austin - Department of Accounting ( email )

Austin, TX 78712
United States

Wuyang Zhao (Contact Author)

University of Texas at Austin - Department of Accounting ( email )

Austin, TX 78712
United States
5128262698 (Phone)

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