How Stock Compensation Effects Analyst Projections for New Firms

Stock based compensation has experienced growth as a form of non-cash compensation to employees. Equity compensation is used to align management’s long-term objectives with those of the company. Stock-based compensation gives management incentives to grow the company responsibly over a somewhat longer term versus making short-term decisions to meet bonus requirements. The longer-term incentive is due to the vesting period of stock options. However, many scholars and practitioners, including Warren Buffet, argue stock options provide shorterterm incentives than shares. Current accounting treatment of stock compensation by investors and analysts alike, however, draws the ire of many business world. Analysts treat stock compensation as a non-cash add back to free cash flow and ignore the costs or dilutive effects. Thus, stock compensation is linked to overvaluation (Mohanram, White and Zhao 2020). This study examines whether equity research analysts who treat stock compensation as a pro forma add back to free cash flow produce statistically different price target prices than those who do not. If considering stock compensation explicitly in valuing a firm improves the accuracy of analysts’ valuation, then I expect analysts that adjust for stock compensation have more accurate price targets. Alternatively, adding stock compensation back to calculate free cash flow may inflate valuation because it ignore the true cost of the options. The sample includes reports from analysts covering a subsample of companies in the technology sector. I compare the forecast error of earnings per share and revenue forecasts for analysts who explicitly consider stock compensation relative to those who do not. I find that the accuracy of analysts’ price targets does not differ significantly based upon stock compensation treatment. This finding implies that the overvaluation effects of stock compensation might not be significant enough to result in higher price targets by analysts who adjust for it.