During his recent interview with Tobias, Partha Mohanram, a Professor of Accounting and John H. Watson Chair in Value Investing at The University of Toronto discussed How Share-Based Compensation Lowers Returns. Here’s an excerpt from the interview:
Tobias: One of your papers that I discovered it after you got in contact with me, but I’m glad that I did because it’s an issue that I think is particularly important right now, and that’s share-based compensation. Basically, you show that higher share-based compensation leads to lower returns, but the way that you get there is by higher valuations. Perhaps, it’d be better if you describe it.
Partha: No, I think it’s a pretty fair explanation. Let me give you a genesis of how this paper came into being. I teach business analysis in valuation, which basically is a financial statement analysis course. One of my students here from Toronto, his name is Wuyang Zhao. He’s now a professor at UT Austin at the McCombs School of Business. He teaches the same thing. And he said, “Hey, Partha, I was looking at this free cash flow calculation, and I found that different books do differently. Some people use cash flow operations where they use the cash flow operations number, and then they simply subtract out CAPEX and probably add back interest something and you get free cash flow. Other people start with net income, subtract out depreciation, and then do the changes in working capital and stuff, and then the CAPEX and all. And the two are different because how they treat these non-cash expenses is different. The second approach starts with net income and therefore, it includes these non-cash expenses like stock-based compensation. It’s the largest of them, by the way. The approach which starts from cash flows, if you look at your cash flow statement, you always add back these things like stock-based compensation because it’s a non-cash expense. And so, it systematically makes this free cash flow higher. The question is, which is the right one?” And there’s no clear answer to that because, yes, stock-based compensation is not a cash expense and therefore, it is right to add it back in the calculation of cash flow. But is it right to exclude it in the calculation of free cash flow? Not so sure, because what is free cash flow?
Free cash flow means that the company has– this is that amount which is truly left over for the shareholders after you’ve taken into account all things you need for your future growth. Think about stock-based compensation. If you’re giving a lot of stock-based compensation to your employees– now, we had this big controversy but since 2005, it’s an expense which you have to account for on your income statement. It is an expense because you are giving up something of value at a lower price to your employees. Now, when you exclude stock-based compensation, you’re excluding the impact of the stock-based compensation on the current shareholders.
The impact can be twofold. Number one, there will be future dilution. If a company does absolutely nothing and allows all these options to get exercised as and when they get exercised, your current shareholders will get diluted because they’ve got to share this wealth of the company with these new shareholders, who happened to be the employees of the company. The second thing which is likely to happen is, to prevent this dilution– if we look at many of these companies in tech and all, they are constantly repurchasing shares to prevent the dilution. How do you repurchase shares? You repurchase shares by using cash. So that cash is not free, it’s being used to essentially service this thing. The only difference is, it makes sense because instead of paying the guy– let’s say you have the choice of paying somebody $100,000 in cash or you pay them $60,000 plus $40,000 worth of options. Yes, you save $40,000 in cash right now, but you’re on the book for it later on when you start repurchasing shares to prevent this guy from diluting your equity. It’s not a free cash flow.
So, we said, “If that’s the case, it must be the case that firm–” Let’s say markets ignore this, they have no clue. They take these numbers mechanically, and they apply multiples and so on so forth. They must be systematically overvalued firms which have a lot of stock-based compensation. So, we asked the question, is it the case that they’re systematically overvaluing these companies? And so, we looked at traditional measures of valuation, your P/E ratios, your price to book ratios, price to sales ratios and stuff. And we found that, yes, these ratios are higher. Now, the obvious question, “Yeah, but that’s obvious. These firms are in tech and these guys are in industries which have higher valuation ratio. So, you’re just showing that.” So, we control for that. We control for industry, we control for your growth and stuff, and we show– even controlling for all of that, then you have stock-based compensation, systematically you have higher valuation ratios.
And the next question, if that’s the case, and if it’s overvaluation, you should see the results in future returns. And we find that systematically, these guys in future– if you look at the next one or two years, the returns tend to be a little lower, because the markets eventually find out that, these guys are not in a sense– or they see the actions that they take to dilute their shareholders or the repurchases or whatever, we don’t know the exact mechanism and we can’t pinpoint exactly when the market sees the light. But if you look at a large sample, that’s what we systematically find.
And again, this goes back to the fact that if you really want to do fundamental analysis properly, you need three skills in my opinion in terms of knowledge of areas of business. You need to understand business, that is strategy and what makes– economics fundamentally, the economics of the industry and so on so forth. You obviously need to understand finance, but the third thing, which I think many people don’t understand is you need to understand accounting. You don’t need to be a CPA, but you need to understand the basics of what an income statement is, what a balance sheet is, what a cash flow statement is, and how these things articulate with each other. Because if you don’t get that understanding, you are going to be the person who uses accounting numbers as a black box and you’re systematically going to get misled.
Tobias: Yeah, I couldn’t agree more. And just on that point, when I wrote a book in 2012, called Quantitative Value with a coauthor, one of the adjustments that we made to Piotroski was to include– in addition to shared purchases, we included share issuance, so we made it share issuance net. Just a tiny little change which slightly improves the performance.
Partha: It improves, okay.
Tobias: And leads to a more intuitive output, the companies that come out. Otherwise, you’re favoring these companies that tend to buy back a lot of stock but often they’re buying back just to tidy up.
Tobias: The option issuance.
Partha: Although to be fair, in Piotroski subset, value stocks, they probably aren’t that many tech companies and stuff. It’s probably a bigger problem in the G-score subsample if you look at that. But certainly if you’re applying Piotroski across the board to all firms, I think that’s certainly a valid and probably very good adjustment to make.
Tobias: It was one of the things that I have observed too. The Piotroski does quite well outside of that book to market decile. It does reasonably well across the entire portfolio. If anything, it’s held back a little bit by the book to market decile because that seems to be such a– they’re very small firms and they’re not great companies in the first instance.
Partha: Right. But actually, if you think about it, that was part of Piotroski’s ideas. You want to invest in these firms. Going back to my analogy, you need the rough to find the diamonds. In fact, the reason why some of those things continue to stay misvalued is simply because people are scared to get into investing there because they don’t meet the cut-offs of size or stock price or liquidity for you to want to go and invest.
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