What is your prediction for range for peak Shiller PE this time?

KJP · August 17, 2021

2 hours ago, thepupil said:

I agree it's an expense. how one should account for it is up to interpretation.

I also agree that equity compensation is an expense, so the question is how to assess it. Thepupil has presented a concrete example, so I'll try to get at a more theoretical issue: The stock-versus-flow mismatch of what I've referred to as the "ex post" approach.

An essential input into the "ex post" method is the actual share price performance of the firm in the years after the equity comp is given. Changes in the stock price presumably reflect changes in the expected net present value of all future cash flows flowing to the firm's equity. In this sense, the market cap of a firm is akin to a balance sheet/stock figure rather than an income statement/flow figure, and changes in equity prices reflect changes in the overall value of this "stock". So, what the ex post method does is take the overall change in value of the firm (embodied in equity price change) and assign it proportionally to the equity granted in a particular year.

An income statement, on the other hand, reflects only (accrual-based) revenue and expense flows in a given year, not changes in the expected cumulative value of the firm's future cash flows. So, doesn't the ex post method distort things by inserting a stock-based measure into a flow-based statement, thereby overstating the true cost of equity comp for companies whose equity price (and presumably underlying value) is increasing rapidly? (A similar problem to putting the full cost of a 20-year asset onto the income statement in the year of purchase.)

I believe the JPM method in thepupil's post is trying to get at this problem by taking stock comp out of the flow-based income statement altogether and putting into the stock-based metric of shares outstanding.

Cigarbutt · August 18, 2021

^Thanks to both of you. The perspectives are quite helpful. The add-back/diluted shares approach seems to work relatively well in many situations. The aggregate disconnect may simply be a reflection of an unusual bull market (which may be fundamentally sound and may simply be a prelude to better things to come?).

One aspect is how to try to match the share-based expense with the actual cashflows to compensate for the agreement to eventually issue shares. When an asset is bought with investing cash flows, the actual depreciating expense happens in operating earnings after, in a fairly predictable way. When the share-based expense is periodically recognized based on grant-date value (then market price), it's not clear which year financing cash flows should be used: those cash flows concurrent to the grant year or those cash flows when shares are issued upon vesting. i like it when companies buy back shares specifically designated for future issuance related to agreed upon longer term share-based compensation. Over time, aggregate financing cash flows allocated to share buy backs have been increasing, absolutely and relatively and, historically, in a mean reverting way, buyback activity has been pro-cyclical.

If one uses the perspective that "Changes in the stock price presumably {and efficiently?} reflect changes in the expected net present value of all future cash flows flowing to the firm's equity", then the NIPA profits need to be adjusted upwards to match the rise in GAAP S&P 500 profits and this would represent, for the 2012-2019 years, about a cumulative 1T amount of profits that the market has recognized (as a measure of future profitability) and that was captured by share-based compensation value upon vesting so that the share-based compensation was not really an expense but more a reflection of better corporate business prospects at large and/or of an unusual collection of circumstances (low interest rates etc) that will continue to support multiples and valuations. The lower NIPA corporate profits, as uncovered by tax paid on capital gains by individual investors, would then simply mean that the employee/management stock was sold to another investor after vesting, with some tax withholding, related to new and better appreciation of flowing future cash flows.

But i'm still not clear on how to adjust for this on a forward looking basis, overall. Is it a virtuous or a vicious cycle? On a company by company level at least, it's seems to be easier to figure out if the way the growing pie is 'shared' with employment and management is reasonable or not.