While analyzing stocks for buy/sell recommendations for the USC Student Investment Fund, I discovered one key factor that often flipped my valuation opinion from buy to sell. This factor is share-based compensation (accounting treatment, here). When it’s added back in a discounted cash flow analysis, cash flow goes up and a stock looks like a buy, yet when it’s subtracted out (like a cash expense), cash flow goes down, making a stock look like a sell.
Share-based compensation is the largest valuation issue that I see discussed the least. Just to give you an idea of how big this issue is, consider the following quote from an academic paper written by Kevin Murphy, a leading expert on compensation practices.
Over the 14-year 1992-2005 time period, the average S&P 500 companies awarded over $1.6 billion worth of options to its executives and employees (or over $800 billion across all 500 companies). What is generally unappreciated is that in this process the average S&P 500 company transferred through options approximately 25.6% of its total outstanding equity to its executives and employees.
Yes, you read that correctly, 25% of equity is given to employees!
Regardless of the fact that nearly one fourth of the average S&P 500 company is given to employees over a 14-year period, Wall Street analysts simply ignore this fact. In their discounted cash flow analyses, Wall Street analysts adjust for share-based compensation, a non-cash expense, by subtracting it pre-tax and adding it back as a post-tax cash flow adjustment. In effect, they are looking through this “expense” and increasing the value of the company by the amount of the tax benefit associated with the tax deductibility of share-based compensation.
Here is a snapshot of the current thinking (see shaded area).
To the untrained eye, this treatment seems reasonable given that share-based compensation is non-cash. The argument typically goes like this: “Hey, just like depreciation, share-based compensation does not affect cash flows, so of course it should be ignored in a discounted cash flow analysis – which is an analysis of cash!” The problem with this logic is that it only goes halfway, because unlike depreciation, share-based compensation has an additional key trait – dilution.
Of course this issue of dilution is no secret, which is why analysts and ibankers everywhere use diluted shares outstanding via the treasury method when analyzing per-share value. The treasury method accounts for historical dilution, but in no way does it address future dilution as a byproduct of future share grants to employees. This is where Wall Street’s logic breaks down. Without an adjustment for future dilution, an analysis of firm value from a shareholder’s standpoint, as of today, is overstated.
Aswath Damodaran, an NYU professor and Wall Street’s valuation guru, is keenly aware of this infraction on behalf of securities analysts. This is why he wrote a paper about the topic, titled Employee Stock Options and Restricted Stock: Valuation Effects and Consequences.
Even Wall Street analysts themselves are beginning to show (publicly) that they are aware of this issue. One example is provided by an Evercore Partners equity research analyst, admitting that Evercore’s 2012 “new year’s resolution” is to treat share-based compensation as an expense (see discussion at 3:10 in the video below).
This analyst is proposing to treat share-based compensation as a cash expense, even though it’s technically not one. More specifically, he’s proposing subtracting share-based compensation just like base salary expense, properly capturing tax deductibility, and not adding it back as a post-tax cash flow adjustment in an attempt to recognize that value (via dilution) is being transferred to employees.
In other words, future cash flows, from a current investor’s standpoint, will be lower by the amount of equity grants to employees. This treatment would look like this (see shaded area):
Using the two examples I have provided, note the size of the difference. 2012 cash flow alone is $10.4mm different, for a difference of approximately 13%. As shown in the graph below, this variance is a material annual issue.
In total, using the graph above, this issue is a $68.5mm adjustment over the forecast period. Not small. Moreover, this addback has an even bigger effect on companies in industries that pay a high proportion of their earnings as share-based compensation. The classic example here is technology companies. They typically have huge option programs (just look at Pandora’s nearly 20% option overhang).
After reading this, you’re probably beginning to ask yourself, “So what’s the right answer? Should I add share-based compensation back like depreciation because it’s non-cash? Or should I depart from cash reality, treating share-based compensation as a cash expense, thereby decreasing the value of the firm by the value of annual stock grants?” The answer is it depends. It depends on what your motives are. If you need a higher value, like most sellside analysts do, it seems that the current answer on Wall Street is add it back. If you need a lower value for the firm, like most buyside investors prefer, then subtract it out. Thus, the answer to the largest unspoken valuation question, one which can easily flip a valuation recommendation from buy to sell, is as easy as this: just remember what side of the table you’re on – then proceed accordingly.