Stock-based compensation, financial analysts, and equity overvaluation

Partha Mohanram (), Brian White () and Wuyang Zhao ()
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Partha Mohanram: University of Toronto
Brian White: University of Texas at Austin
Wuyang Zhao: University of Texas at Austin

Review of Accounting Studies, 2020, vol. 25, issue 3, No 6, 1040-1077

Abstract: 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) (search for similar items in EconPapers)
JEL-codes: G10 G14 M4 M41 (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (2)

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DOI: 10.1007/s11142-020-09541-0

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