For the Valuation of Firms (JEL G32 and G14)
ISSUE Stock based compensation (SBC), the granting of stock in lieu of cash payment, continues to perplex analysts even after its uniform reporting as an expense (FAS 123r, 2004, and IFRS 2, 2004). A firm, such as Netflix, may report a net loss due to SBC expenses while simultaneously reporting billions of positive cash from operations. Stocks retain positive prices despite retained earnings made negative by an expense never requiring a cash outflow. Technical analysts sometimes include and other times exclude SBC as an expense in the net income they use for recommendations (Barth, et al., 2008). Valuation analysts ignore net income (and SBC expensing) and focus on cash from operations (WSJ blog). No study has been made of how total firm value behaves with regard to the expensing of SBC.
OBJECTIVES This paper contrasts total market capitalization of SBC and non-SBC firms. Two relationships are studied: (1) SBC (and non-SBC) earnings and total market capitalization; (2) the free cash flow of SBC (and non-SBC) firms and total market capitalization. Results provide insight on the usefulness of SBC expensing in the valuation of firms.
METHOD Data are gathered from Wharton Research Data Services for years 2006 to 2011. SBC firms are selected. Non-SBC firms are paired by industry and approximate size. In SBC dominant industries, e.g., information technology, paired firms are limited. The relationship of market capitalization to earnings is captured in indexes, adjusted for growth rates and risk: change in market capital-ization divided by change in earnings (or free cash flow): IESBC; IENSBC; IFCFSBC; IFCFNSBC. These form a 2 x 2 matrix of indexes:
Earnings Free Cash Flow
Stock Based Compensation IESBC IFCFSBC
Non-Stock Based Compensation IENSBC IFCFNSBC
Hypothesis 1: market capitalization-to-earnings is the same between SBC and non-SBC firms.
Hypothesis 2: market capitalization-to-free cash flow is the same between SBC and non-SBC.
Hypothesis 3: market capitalization-to-earnings is the same as market capitalization-to-free
cash flow for SBC firms.
Hypothesis 4: market capitalization-to-earnings is the same as market capitalization-to-free
cash flow for non-SBC firms.
RESULTS (expected) Hypothesis 1 rejected--SBC expensing reduces earnings per share; share price declines; but, total firm value fails to change in the same manner between SBC and non-SBC firms. Shares may be worth less, but the firm may be worth more.
Hypothesis 2 rejected weakly--Free cash flow increases by the tax benefit from a SBC expense (and less cash is paid for services). Total capitalization increases for SBC firms (vs. non-SBC firms) despite reduced share prices.
Hypothesis 3 rejected strongly—In SBC firms, market capitalization changes differently with regard to earnings than to free cash flow. Market capitalization follows free cash flow change.
Hypothesis 4 rejected-- In non-SBC firms, market capitalization changes differently with regard to earnings than to free cash flow. Overall, free cash flow has greater influence on firm value—SBC expensing is irrelevant.