Stock-based compensation, or SBC for short, is one of the most controversial expenses in the financial world today. SBC is stock used to compensate a company’s employees. GAAP requires that companies expense SBC on the income statement, since it reduces the value of shareholder equity through dilution down the road. But many companies with a lot of SBC argue that because it’s a non-cash expense, SBC shouldn’t be counted as a normal operating expenses. Thus, many companies with a lot of SBC report non-GAAP earnings figures that exclude SBC — and many times, those SBC exclusions can be quite big.

Naturally, this inflates non-GAAP earnings relative to GAAP earnings. But does this inflation cause overvaluation, or is it actually better to ignore SBC all together?

Recent research suggests the former. In a recent study, Professor Partha Mohanram of the University of Toronto, alongside Brian White and Wuyang Zhao from the University of Texas at Austin, examined the relationship between a stock’s performance and the amount of SBC on its income statement. They found that stocks with more SBC had richer valuations and produced lower returns, than stocks with less SBC. Further research indicated that this under-performance is a byproduct of overvaluation, thanks to aggressive, non-GAAP sell-side price targets that ignore SBC.

The investment implication? Be wary of stocks with too much SBC, and which report non-GAAP earnings that exclude SBC.

With that in mind, I’ve put together a list of 5 overvalued stocks with a ton of SBC, that investors would be wise to steer clear of for the foreseeable future. Those stocks are as follows.

Workday (WDAY)

SBC as a % of Revenue Last Quarter: 23.5%

GAAP Earnings vs Non-GAAP Earnings Last Quarter: -$0.53 vs $0.44

Red-hot cloud ERP giant Workday (NASDAQ:WDAY) leverages huge amounts of SBC, which helps the company disguise itself as profitable when GAAP net losses are actually fairly wide.

Last quarter, the company paid out just shy of $210 million in SBC, in a quarter where revenue totaled less than $890 million. Thus, the SBC rate was a whopping 23.5% — and after Workday added that 23.5% chunk of revenue back into its profits, the company’s huge GAAP net loss of 53 cents per share, turned into a sizable non-GAAP profit of 44 cents per share.

WDAY stock trades at over 100-times forward non-GAAP earnings estimates — which, as we just saw, are hugely inflated relative to GAAP profits. That multiple just seems too big for this stock, especially considering revenue growth is slowing and the margin expansion trajectory is flattening out.

Net net, I’d be cautious with respect to WDAY stock at current levels.

Snap (SNAP)

SBC as a % of Revenue Last Quarter: 50.4%

GAAP Earnings vs Non-GAAP Earnings Last Quarter: -$0.19 vs -$0.06

Shares of hyper-growth social media platform Snap (NYSE:SNAP) have been on fire in 2019, as the company has wowed investors with renewed user growth and significant margin improvements. But underneath those big margin improvements, is a bunch of SBC, which — if you factor it back in — makes the margin improvement narrative look much less attractive.

Last quarter, Snap doled out over $195 million in SBC. The company only did about $390 million in revenue that quarter. Thus, SBC equaled more than 50% of Snap’s total revenue last quarter. After adding that SBC back to its GAAP numbers, Snap cut its GAAP net loss of 19 cents per share, down by essentially two-thirds, to a much narrower loss of 6 cents per share.

In other words, Snap’s use of SBC makes the company seem like it is a lot closer to profitability than it actually is. This is worrisome, because Snap doesn’t even project to be profitable on a non-GAAP basis until two years down the road, according to consensus Street estimates, and SNAP stock trades at 75-times those non-GAAP EPS estimates that are two years out.

Sound overvalued? It should. And that’s why I think caution is warranted on SNAP stock.

Cronos (CRON)

SBC as a % of Revenue Last Quarter: 19.5%

GAAP Earnings vs Non-GAAP Earnings Last Quarter: N/A

Pot stocks are infamous for suffering from overvaluation and too much hype. Canadian cannabis producer Cronos (NASDAQ:CRON) was the poster child of overvalued pot stocks in 2019, as investors simply got way too excited earlier this year about the company’s huge investment from Altria (NYSE:MO). CRON stock has since collapsed, but even after this plunge, the stock still seems richly valued if you look at the SBC picture.

Last quarter, CRON’s SBC totaled CAD $2 million while revenues totaled just over CAD $10 million. Thus, the SBC rate was narrowly under 20%.

For anyone who follows pot stocks, this should jump out as a red flag. The biggest concern in the cannabis industry right now is a lack of profitability. That is, these companies appear to be miles away from achieving even non-GAAP profits. That dour profitability picture becomes even more bleak if you consider that non-GAAP profits are inflated by huge SBC.

The big idea? CRON stock projects to be narrowly profitable next year, based on non-GAAP Street estimates. On a GAAP basis, it may be another few years before this company strikes a profit. Yet, CRON stock trades at over 100-times trailing sales. That’s just too big of a multiple for an unprofitable company.

HubSpot (HUBS)

SBC as a % of Revenue Last Quarter: 17.6%

GAAP Earnings vs Non-GAAP Earnings Last Quarter: -$0.41 vs $0.37

Hyper-growth enterprise software company HubSpot (NASDAQ:HUBS), much like other hyper-growth companies on this list, leverages huge amounts of SBC to turn huge GAAP losses, into sizable non-GAAP profits.

Last quarter, HubSpot paid out just under $29 million in SBC. Revenues in the same quarter totaled just over $163 million, giving the company an SBC rate of 17.6% last quarter. This huge SBC expense was the biggest driver in flipping last quarter’s huge GAAP net loss of 41 cents per share, to a sizable non-GAAP profit of 37 cents per share.

That’s a problem. But the bigger problem here is that HUBS stock trades at 114-times forward non-GAAP earnings, while revenue growth is 30% and slowing. That just seems like too big of a multiple for what will reasonably be a 20% revenue grower over the next few years, especially considering that those non-GAAP earnings are inflated tremendously by a ton of SBC.

Big picture — be wary of the valuation underlying HUBS stock.

Atlassian (TEAM)

SBC as a % of Revenue Last Quarter: 22.8%

GAAP Earnings vs Non-GAAP Earnings Last Quarter: -$0.99 vs $0.20

Australian enterprise software company Altassian (NASDAQ:TEAM) has been one of the market’s favorite growth stocks for the past several years because the company has blended big revenue growth with strong margin expansion. But the strong margin expansion has been artificially inflated by a ton of SBC, and when you strip that out, TEAM stock seems way overvalued.

Here’s the deal. Altassian shelled out more than $76 million in SBC last quarter. Revenues totaled roughly $335 million in that same quarter. The SBC rate? Almost 23% of revenues, which was a big driver in flipping last quarter’s IFRS net loss of 99 cents per share, to a non-IFRS net profit of 20 cents per share.

Thus, SBC is artificially inflating Altassian’s profits by a lot. TEAM stock is trading at 123-times those inflated earnings, on a forward basis. That simply seems too rich. Sure, the company is growing very quickly, but quickly enough to justify a triple digit forward earnings multiple on SBC-inflated profits? Nope. Revenues are expected to grow under 30% this year, while margins aren’t expected to expand by much.

That just isn’t enough growth firepower to warrant the premium valuation on TEAM stock. The implication? Stay away.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.