A CONVERSATION WITH MICHAEL MAUBOUSSIN ON STOCK-BASED COMPENSATION, INTANGIBLE INVESTMENTS, AND CORPORATE PERFORMANCE

August 18, 2023

Michael Mauboussin is a celebrated financial expert, author, and professor. He is Head of Consilient Research at Counterpoint Global, a Morgan Stanley Investment Management division. He is the author of multiple books, including The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, and Think Twice: Harnessing the Power of Counterintuition, and has won several awards for teaching excellence. This interview explores three papers he has recently co-authored with Dan Callahan, CFA.

What are some of the evolving market trends and compensation program designs that have led to the five-fold increase in stock-based compensation (SBC) from 2006 to 2022?

A few potential explanations come to mind. First, SBC was out of favour following the dot-com bust, and the early 2000s were a bit of a bounce back. Second, the mix of businesses that make up the market shifted to include more technology companies, a sector that has historically been a heavy user of SBC. Third, the stock market generated good returns following the Great Recession of 2007–2009, which meant that SBC was good for employees, and shareholders worried less about the negative effect of dilution.

You point out that companies target compensation above the median to attract and retain talent, causing compensation to increase over time. With SBC making up an increasing proportion of the mix, is it fair to conclude that SBC represents an increasingly large wealth transfer from shareholders to employees over time?

This is difficult to answer because there is no easy way to know the “right” amount of executive pay. On the one hand, a competitive labour market plays a role in setting compensation. On the other hand, large companies in countries other than the US, including most of Europe, have lower executive pay than the US for similar executive roles.¹ Thoughtful shareholders should pay attention to how and how much executives are paid.

Companies issue stock to non-executives to foster an ownership mentality. How do non-executive employees value SBC relative to cash, and how do market conditions impact perceived value?

Research suggests that employees are not great at valuing the equity they receive. Right off the bat, we should expect employees to value equity less than an equivalent amount of cash because of risk aversion and a lack of liquidity. Further, if management believes its company’s shares are undervalued, issuing SBC is a potentially inefficient way to pay employees.

But the real question is whether SBC is a means to foster an ownership mentality, aligning employees with shareholders, or a means to deliver pay. In 2022, the Russell 3000 Index was down 19 percent, and SBC was up 19 percent. That suggests that SBC was used to deliver pay.

Companies usually add back SBC in their non-GAAP (generally accepted accounting principles) results, and most sell-side analysts add back SBC to free cash flow estimates. Given these numbers’ role in informing markets, can we draw any conclusions about their influence on valuations?

The research shows that most analysts add back SBC in their discounted cash flow (DCF) models, and the analysts who do have higher target prices than those who don’t.² Further, the companies in the top quintile of SBC issuance had lower total shareholder returns than those in the bottom quintile.

That said, it is conceptually equivalent, from the point of view of valuation, to treat SBC as an expense or as dilution via rising shares outstanding. So, in theory, it should not matter how an analyst treats SBC. However, most analysts struggle to reflect dilution accurately. I prefer to treat SBC as an expense, but a DCF model can capture SBC as dilution.

The situation is a lot trickier with valuation via multiples. DCF models reflect cash flows over time, while multiples rely on snapshots—for example, today’s enterprise value (EV) divided by next year’s earnings before interest, taxes, depreciation, and amortization (EBITDA). Valuation via a snapshot is inherently limited in its ability to reflect changes in SBC levels that may appear on the income statement, cash flow statement, or shares outstanding.

Using buybacks as a signpost for good capital allocation has become increasingly difficult. Companies are increasingly executing buybacks to offset SBC dilution and seem agnostic to valuation. How should investors think about simultaneous SBC issuances and buybacks when analyzing companies?

You’re correct to note that executives link SBC to buybacks— a recent survey found that 68 percent of CFOs said that offsetting dilution from SBC was “important” or “very important” in their decision to buy back stock.³

A fundamental capital allocation rule is “buy low and sell high.” Applied to equity, you want a company to “retire low and issue high.” You can see the issue immediately: if a company is both issuing via SBC and retiring via buybacks, the fundamental rule of capital allocation is at risk of being violated.

I like to see companies consider SBC and buybacks as separate issues. It is also worth noting that buybacks are a lot bigger than SBC. For example, in 2022, companies in the Russell 3000 bought back US$1.1 trillion of stock, and SBC was US$270 billion—so the ratio of buybacks to SBC was about 4.1.

We have already seen that lots of SBC issuance is associated with poor shareholder returns. Still, it’s worth adding that whether a company sells or buys equity is also a critical signal. The basic story is that lots of equity issuance is associated with poor shareholder returns, and retirement is associated with good returns. While every company’s circumstances differ, the aggregate figures are well-established in the research literature.⁴

In your research paper, “Good Losses, Bad Losses,” you showed that companies referred to as “GAAP Losers” (the set of companies that booked negative GAAP net income only because of intangible investments) outperformed “Real Losers” (companies with expenses exceeding sales) and “Profitable Firms” over the last two decades. Given that some of the intangible investment was likely made in the form of stock grants to research and development (R&D) staff, can we draw any conclusions on the impact of SBC on performance?

Figure 1

Source: Maboussin, Michael J., and Dan Callahan. “Good Losses, Bad Losses: All Losses Are Not Created Equal.” Consilient Observer (2022), Morgan Stanley Investment Management.

Let’s back up one step. It is essential to acknowledge the rise of intangible investments, which, by our calculations, are now substantially larger than tangible investments in the US. The main analytical challenge is determining how much R&D, and non-R&D selling, general and administrative expenses, should be treated as an intangible investment.⁵ This treatment means adding the expense to the income statement and net amortization costs, and reflecting the intangible investment on the balance sheet. In a nutshell, capitalizing intangible investment increases earnings and invested capital.

This is important for companies that lose money because they are making lots of intangible investments that are expensed. The analyst must still determine whether those investments will generate a sufficient return, but recategorizing items on the financial statements adds analytical clarity.⁶

The academics who found that “GAAP Losers” delivered higher returns than “Real Losers” showed that accounting practices can distort economic reality.⁷ Earnings can come up short in revealing the magnitude and timing of cash flows.

How does implementing the prescribed adjustments for intangible investments and SBC affect return on invested capital (ROIC) and, ultimately, valuations?

The adjustments we suggest do not affect value at all. The value of a business is the present value of free cash flow (FCF), defined as net operating profit after taxes (NOPAT) minus investment in future growth. The intangible adjustment reclassifies expenses as investments. This increases NOPAT and investment by an identical amount. FCF does not change.

Our ROIC calculations assume that SBC is an expense, which is already how they are treated on the income statement.

The continuing value calculation is one area where the adjustment can affect valuation in a DCF model. In cases where the continuing value is based on earnings in the final year of the explicit forecast period, the continuing value will be higher—assuming the same methodology—following the adjustment for intangible investment.