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The web site itself may have changed. You can check the current page or check for previous versions at the Internet Archive. Yahoo! is not affiliated with the authors of this page or responsible for its content. Do Stock Prices Incorporate the Potential Dilution of Employee Stock Options? Do Stock Prices Incorporate the Potential Dilution of Employee Stock Options? Gerald T. Garvey Todd T. Milbourn February 3, 2003 We wish to thank Gene Fama for the Fama-French factors and Stuart Gillan for the data on option exercises. Thanks also to Kerry Back, Murray Carlson, Jennifer Carpenter, Heber Farnsworth, Ron Giammarino, David Hirsh-
leifer, Steve Huddart, Kathy Kahle, Ali Lazrak, Mike McCorry, Harold Mulherin, Greg Roth, Richard Smith, Siew
Hong Teoh, Sheridan Titman, Je Wurgler, and seminar participants at Washington University in St. Louis, Univer-
sity of British Columbia, and Barclays Global Investors for useful suggestions. We are grateful to Xifeng Diao who
provided expert research assistance and computational support. Peter F. Drucker School of Management, Claremont Graduate University, Claremont CA 91711 Tel: 909-607-9501 e-mail: gerald.garvey@cgu.edu Washington University in St. Louis, John M. Olin School of Business, Campus Box 1133, 1 Brooking Drive, St. Louis, MO 63130-4899 Tel: 314-935-6392 Fax 314-935-6359 e-mail: milbourn@olin.wustl.edu website:
http://www.olin.wustl.edu/faculty/milbourn/ 1 Do Stock Prices Incorporate the Potential Dilution of Employee Stock Options? Abstract Employee stock options represent a signicant potential source of dilution for shareholders in many rms. It is well known that reported earnings systematically understate the associated costs, but an ecient stock market will show no such bias. If by contrast stock prices fail to fully incorporate the future costs implied by stock option grants, option exercises will produce negative abnormal returns. We design and implement a stock-picking strategy based on predictions of stock-option exercise using publicly-available information. We are able to identify stocks that subsequently exhibit signicant negative abnormal returns using either a CAPM or three-factor Fama-French benchmark. We also nd weak evidence that the returns are more negative for rms whose earnings shocks are more persistent, as predicted in a recent theoretical model in which limited investor attention is the source of mispricing. More consistent with the notion of limited investor attention, we nd our results to be stronger in months where rms issue quarterly reports which alert investors to any dilution stemming from the exercise of employee stock options. 2 1 Introduction In the growing controversy over o-balance sheet liabilities and potentially inated earnings re- ports, employee stock options take pride of place (see The Economist (2000), Byrnes (2002), and Morgensen (2002)). For example, the Investor Responsibility Research Center (2001) reports that just over 14% of the equity of the average S&P 500 rm has been promised to employees through stock option plans. 1 Under current US accounting rules, stock option grants are not expensed, are not recorded on balance sheets, and are only partially reected in diluted Earnings Per Share. In 2003, Standard & Poors will introduce a new data item that it terms Core Earnings which will expense employee stock option grants using Black-Scholes values, and major rms such as Coca-Cola and General Electric have promised to do the same to their future earnings reports. 2 The controversy over how employee stock options should be treated in accounting reports has largely neglected the question of whether market prices already account for the associated costs. 3 If prices do not reect these costs, it should then be possible to devise a protable stock selection strategy based on public information. Jenkins (2002) states the case with much stronger language: Myth: Failing to deduct an expense for management stock options inated earnings
and therefore stock prices. Good grief. Weve been discussing this rule change for a decade now. It would be the overripe short-selling opportunity of the century if the
market were somehow fooled into mispricing stocks simply because we failed to adopt
a particular accounting treatment for the non-cash value of options. To formulate a test of this hypothesis, we begin with the assumption that investors eectively disregard at least a portion of the costs of stock option grants. 4 An obvious implied trading strategy is to short or downweight rms with large amounts of employee options outstanding, but this is an incomplete strategy. The unaddressed question is exactly when do investors realize the costs of options and drive prices back to fundamentals? 5 We assume that prices do not reect 1 The Economist (2000) reports that the Black-Scholes value of employee stock option grants in 1999 was just over 6% of the earnings of an average S&P 500 rm. Core and Guay (2000) document that the Black-Scholes value of
employee stock options average almost 4% of the market capitalization of the average large corporation, with values
at the upper end of the spectrum approaching 24%. Sanford F. Bernstein & Co estimates that if option grants had
been expensed, prot growth for the S&P 500 over 1997 through 2001 would drop from 9% to 6% (see Morgensen
(2002)). 2 See Standard and Poors (2002). 3 One can also interpret these costs as dilution, as the distinction between the two is semantic. Interpreting stock options as a cost to shareholders aects the expected cash ows to a rm, whereas treating them in terms of their
dilution aects the number of outstanding shares. Both interpretations result in the same price per share. The
substantive problem we analyze is that current accounting standards do not report either dilution or cost at the grant
date. 4 While our work simply posits such behavior as our starting point, Hirshleifer and Teoh (2002) show explicitly how such mispricing can stem from limited attention and processing power on the part of investors. 5 See DeLong, et al (1990) for an example of a research design that seeks to identify how quickly market mispricing is corrected. 3 option costs until they materialize upon exercise by employees. Observe that we cannot rule out temporary mispricing in which the market adjusts to reect the costs of option grants with some unspecied lag. Searching for such an eect would inevitably result in data-snooping, because in hindsight there is sure to be at least one period in which option-granting rms have lower than expected returns. Indeed, Yermack (1997) and Ittner, et al (2002) nd that rms tend to perform somewhat better than expected in the year following large option grants. Our contention is that if investors neglect option costs, there is no reason to expect any correction in the subsequent year since no additional information about the option grant will emerge. A benet of formulating the test as a trading rule is that it forces the researcher to recognize many of the constraints that an active investor would face. 6 Most importantly, we must use forecasted option exercises, rather than realized option exercises used by Carpenter and Remmers (2001) and Huddart and Lang (2002). Their research can ascertain whether executives made well- timed trades based on their own information, but it is mute on the question of market eciency unless the market is sluggish in its reaction to the revelation of an insider sale. 7 By contrast, we use public information to forecast future exercises and form our portfolios in anticipation of such exercises. This empirical strategy is most sensible for two reasons. First, the relevant data for the exact date at which employees exercise is unavailable save for the top executives in the rm. This data constraint precludes the use of an event-study methodology. Second, even if we were to use a longer estimation window, the results would be biased because employees will only exercise their options if the stock has performed well enough to make the options suciently valuable to exercise. To predict the year in which employee exercise will take place, we rely on a typical, three- year vesting schedule of employee stock options, in conjunction with results documented in existing research on the decision to exercise such options (see Huddart and Lang (1996) and Heath, Huddart and Lang (1999)). 8 We then test the more rened proposition that prices will reect exercises primarily in months where the rm issues quarterly reports; such reports alert shareholders to the net eect of stock option exercises on the rms balance sheet. 6 Core, et al (2000), Huson, et al, (2000) and Aboody, et al (2001) nd some evidence that market values of equity are lower when option liabilties are greater. While these studies are consistent with the view that stock prices already
incorporate option costs, they have limited power to reject the hypothesis of market eciency. First, the regressions
require that book value, earnings, and earnings forecasts provide an adaquate control for other determinants of value.
Perhaps as a result of potential misspecication problems, the result that option costs are reected in lower market
value does not hold in all specications. Second, the estimated eect of option costs on value is generaly less than
one-for-one. We cannot tell if this is due to error in measuring option costs or to the market only taking partial
account of stock option costs. 7 See Seyhun (1998) for an exhaustive treatment of the investment value of insider trading disclosures. 8 That is, we assume that options granted during the year 1992 will have vested by the beginning of 1996 since at least three full years will have passed. In our empirical analysis of how well our predicted exercises explain realized
exercises in a small sample (Table 4 ), we document successes for both this three-year cli-vesting schedule and the
25%-per-year vesting schedule. 4 To estimate the costs of expected option exercises, we use Standard and Poors ExecuComp data for each of the years 1992 to 1996, thereby forming our trading strategy over the years 1996 to 2000. This restricted time-series is driven by our assumption that stock options dont vest until the beginning of the fourth year after which they were granted, coupled with the fact that the ExecuComp data does not begin until 1992. Despite this limitation, we estimate a reliable and negative relationship between abnormal returns and our measure of the unrecognized cost of employee stock options. Specically, using either a portfolio alpha approach or the Fama and MacBeth (1973) method, we nd that the results are signicant at the 5% level or better for both CAPM and Fama-French abnormal returns. Moreover, we nd that the eects tend to be stronger in months when quarterly reports are issued. Obviously, our time-period is unrepresentative in that the market performed better than its historical average. However, we continue to nd evidence that the market underestimates the costs of stock options even after controlling for rm xed eects, that is, after setting each rms expected returns equal to its average realized return over our time period 1996 to 2000. The paper is organized as follows. Section 2 presents a simple model that highlights the key measurement and accounting issues, as well as the assumptions required for our trading rule to work. Section 3 summarizes our data and how we put together our stock selection rule. Section 4 analyzes the performance of our trading rule. In Section 5 we provide further evidence on Hirshleifer and Teohs (2002) model of limited investor attention. Section 6 presents our sensitivity analyses and Section 7 concludes. The Appendix contains the proof of our main proposition. 2 A Simple Model Consider an all-equity rm with n shares outstanding plus m identical employee stock options, each with an exercise price X. The present value of the rms future cash-ows is denoted by V . We consider two periods. The rst period corresponds to the time that we make our stock selections, at which point all parties agree that V = V 0 and that rm value in the second and nal period is distributed according to the distribution F (V ). In this terminal period, employees can exercise their options and will choose to do so if their options are in the money. While the results in this section hold for any distribution of terminal values, in our empirical work we will eectively assume that it is log-normal because we use the Black-Scholes-Merton formula to approximate the value of options. Denote by P 0 the stock price at the initial period and denote the stock price in the terminal 5 period by P 1 . If options expire out of the money, there will be only n shares outstanding so P 1 (out) V n . If by contrast options expire in the money, the shareholders receive a cash infusion of mX, but must also issue m additional shares, thus P 1 (in) V +mX n+m . Denote by V nX the critical terminal value of V at which the options are just at the money. This value is unique since P 1 (in) = P 1 (out) only at V = V = nX. Our interest in this paper is whether the market properly anticipates the costs of stock options, so our attention is focused on the initial price P 0 . Since the expected market rate of return is assumed zero, a price that appropriately anticipates stock option costs along with the distribution of returns simply equals the expected value of the terminal price. Since the terminal price is V n if V V and V +mX n+m otherwise, we can write the price that correctly anticipates option dilution as P 0 = V Z 0 V n dF (V ) + Z V V + mX n + m dF (V ). (1) Observe that an estimate of P 0 in our model requires knowledge of the number of options granted m and the exercise price X. In practice, these values have in fact been reported at the option grant date in footnotes of annual reports since 1992. The costs are not, however, integrated into rm earnings at the grant date, nor is the evolving liability recorded on the balance sheet. An extreme view would be that the market completely ignores stock option costs, in which case the initial price would simply be given by E(V ) n . While we present evidence consistent with this view in the empirical section, we focus on the somewhat less extreme hypothesis that investors make use of the information summarized in diluted earnings per share according to SFAS 128, but do not take account of the full costs of options. SFAS 128 requires rms to recognize an additional number of shares equal to max[0, m(P 0 X) P 0 ]; see, for instance, Core, et al (2000). Put into valuation terms, SFAS 128 assumes that if options are currently not in the money, then there is no option dilution, while if they are currently in the money, the options will be immediately exercised. 9 Following this logic we dene: P Acc 0 =
R 0 V n dF (V ) if R 0 V dF (V ) V R 0 V +mX n+m dF (V ) otherwise. (2) Clearly, the above price does not correctly incorporate the expected cost of option exercises as is done in equation (1). It either assumes that the options will never be exercised, or that they will always be exercised. Our purpose in this section is to derive the empirical implications of a 9 Currently here means at the scal year-end. For convenience, we henceforth assume that time 0 is the end of the scal year. We incorporate dierences between price at portfolio formation time and at the end of the scal
year in our empirical work. 6 world where investors are misled by the accounting treatment of stock options to systematically underestimate their cost. Formally, the model yields the following result. Proposition 1 If the initial stock price is P 0 , then the expected abnormal return on the stock is zero. However, if the initial price is P Acc 0 , the expected abnormal return is equal to mU nP 0 , where nP 0 is the rms initial market capitalization and U = R V V nX n+m dF (V ) max[0, P 0 X] is the unrecognized cost of a single employee stock option. The intuition behind this result is straightforward. If investors underestimate the expected costs of employee stock options, the expected abnormal return is clearly negative. This implica- tion is a direct consequence of our assumption that P Acc 0 eectively ignores the time value of the options. Hirshleifer and Teoh (2002) provide a model that endogenizes such a specication, and their Proposition 5 contains the analogous prediction that if some investors have limited attention and stock options are not expensed at the time they are granted, the market will overvalue rms relative to fundamental value, with greater overvaluation being associated with larger employee stock option grants. 10 An additional implication of their model that is beyond the scope of our reduced-form approach is that as the persistence of earnings increases, the greater will be the over- valuation due to employee stock options and the more negative the abnormal return will be upon exercise. We test the proposition empirically in Section 5. Proposition 1 eectively characterizes expected returns, conditioning only on the characteristics of the stock option grant (m and X). While we report results with raw returns in our empirical section, we focus on market-adjusted returns to each stock to isolate underperformance from any correlation between stock option costs and systematic risk factors. In addition to the relationship between raw and risk-adjusted returns and option values, it is also possible to estimate expected returns conditional on observing option exercise. Such a test would not address the question of whether or not the market appropriately prices the costs of employee stock options, because em- ployees will exercise only if V > V . That is, we expect to see a positive relationship between employee stock option exercises and prior stock market performance, even if investors had overval- ued the rm by neglecting the fact that employees will share in good stock price performance. 11 10 Hirshleifer and Teoh (2002) provide an opposite prediction for the situation in which the expected option costs are fully expensed at the time of granting, resulting in rms being undervalued. However, since current U.S. accounting
standards do not require such full expensing, this prediction remains untested. 11 As emphasized earlier, prior research has documented a negative relationship between option exercises and 7 We conrm this relationship empirically in our Table 3, but it is of secondary interest. The more important implication of Proposition 1 is that the stocks of rms with large amounts of expected option exercise will perform worse than they otherwise would have, and operationally this means that they will underperform their market-based benchmarks. There are two key issues that our simple two-period model does not address. The rst is the choice of the initial period. This is arbitrary in the theory. To reect accounting reality, however, we have to recognize that P Acc refers to the price at the end of the last scal year since this is the price that is used in computing the most recent version of diluted EPS. The second timing issue is the terminal point. In the model, the ending point is the date that the employees exercise their options. The contractual maturity of most employee stock options is 10 years. Thus, if employees behave according to risk-neutral option pricing, we would observe exercises before 2002 only for those rms that grant options with maturities less than 10 years and for those with extremely high dividend payouts. It is, however, well known that employees exercise grants soon after vesting if the option is in the money (see Huddart and Lang (1996) and Heath, Huddart and Lang (1999)). Indeed, SFAS 123 requires rms to disclose in footnotes (not earnings) the Black-Scholes value of option grants but leaves them free to assume maturity dates far less than the contractual maturity in so doing. Our model does not endogenize early exercise (see, e.g. Meulbroek (2001) and Hall and Murphy (2000) for models that do so based on employees lack of diversication), but the model is consistent with this practice. We interpret V as the level of rm value at which the employee chooses to exercise. In the real-world with early exercise, if the actual value at the end of a period before maturity falls below V , it does not mean that the option actually expires out of the money. Rather, it means that the option remains alive, to be potentially exercised in subsequent periods. We now turn to the construction of our stock selection rule to delineate exactly how we deal with these issues. 3 Data and the Stock-Selection Procedure 3.1 Estimating the Costs of Option Exercises Our stock selections are based on employee option information from Standard and Poors Execu- Comp, combined with market data from CRSP. ExecuComp reports key information about option subsequent stock returns, but this is most plausibly explained as reecting employees informational advantages and
does not address the question of semi-strong-form market eciency. 8 grants to executives for the S&P 1500 rms (including the S&P 500, the S&P Midcap, and the S&P Smallcap) starting in 1992. The database covers at most ve executives, but also reports the percentage of total option grants in a given year represented by a given executive option grant. 12 ExecuComp also provides summary information on options granted before 1992, but only for the top ve executives. We have no data on the scale of grants to all employees before that date. For the grant data starting in 1992, we assume that other employees have options with the same exercise price as the executives, which amounts to assuming that they receive their grants at the same time. For most rms in our sample, this is sucient. However, nearly 35% of the rms in our sample made multiple grants to the CEO and/or to other executives. We assume that employees receive grants in the same proportion as the CEO. That is, the CEOs grant is assumed to be a scale replica of the total option grant at his/her rm. Our trading rule also requires an estimate of when employees exercise their options, and the associated costs to shareholders. Huddart and Lang (1996) and Heath, Huddart, and Lang (1999) both document spikes in employee exercises at options vesting dates if they are in the money. We make our stock selections at the beginning of each year and can only use information at that time. Proposition 1 tells us that the expected negative abnormal return is just equal to the unrecognized cost of the options, scaled by the current market capitalization of the rms equity. To estimate the unrecognized cost we use the Black-Scholes-Merton value less the intrinsic value of the options at the end of the scal year. Since our selections are made for a given year, we also assume a maturity of one year in computing our Black-Scholes values. Obviously, more frequent selections would increase the power of our tests, but the underlying option data is only annual. Below, we describe two ways in which we can at least use stock price information to update our option cost estimates more frequently than once per year. Our primary rule for computing option costs is computed as follows. In 1992, we take the number, n 1992 , and exercise price of options granted, X 1992 , for each rm, and then look forward to the end of scal-year 1995. At this point we estimate the volatility for each rms stock returns using the previous ve years of monthly data. We compute the intrinsic value version of the dollar option cost as the maximum of zero and the dierence between the stock price at the end of the rms scal 1995 and the exercise price. This number, scaled by market capitalization, is 1992s contribution to diluted earnings per share computed according to SFAS 128 (see Core, Guay, and Kothari (2000)). Our forecast of the unrecognized dollar cost of options that will be realized in 1996 computes the Black-Scholes value of options granted in 1992, valued at the end of 1995, and 12 Thanks to Wayne Guay for alerting us to the presence of this data item. 9 assumes a one-year maturity. More formally, for each rm we compute U 1996 = n 1992 (C(P 1995 , X 1992 , d, , T = 1) L
The web site itself may have changed. You can check the current page or check for previous versions at the Internet Archive. Yahoo! is not affiliated with the authors of this page or responsible for its content. Do Stock Prices Incorporate the Potential Dilution of Employee Stock Options? Do Stock Prices Incorporate the Potential Dilution of Employee Stock Options? Gerald T. Garvey Todd T. Milbourn February 3, 2003 We wish to thank Gene Fama for the Fama-French factors and Stuart Gillan for the data on option exercises. Thanks also to Kerry Back, Murray Carlson, Jennifer Carpenter, Heber Farnsworth, Ron Giammarino, David Hirsh-
leifer, Steve Huddart, Kathy Kahle, Ali Lazrak, Mike McCorry, Harold Mulherin, Greg Roth, Richard Smith, Siew
Hong Teoh, Sheridan Titman, Je Wurgler, and seminar participants at Washington University in St. Louis, Univer-
sity of British Columbia, and Barclays Global Investors for useful suggestions. We are grateful to Xifeng Diao who
provided expert research assistance and computational support. Peter F. Drucker School of Management, Claremont Graduate University, Claremont CA 91711 Tel: 909-607-9501 e-mail: gerald.garvey@cgu.edu Washington University in St. Louis, John M. Olin School of Business, Campus Box 1133, 1 Brooking Drive, St. Louis, MO 63130-4899 Tel: 314-935-6392 Fax 314-935-6359 e-mail: milbourn@olin.wustl.edu website:
http://www.olin.wustl.edu/faculty/milbourn/ 1 Do Stock Prices Incorporate the Potential Dilution of Employee Stock Options? Abstract Employee stock options represent a signicant potential source of dilution for shareholders in many rms. It is well known that reported earnings systematically understate the associated costs, but an ecient stock market will show no such bias. If by contrast stock prices fail to fully incorporate the future costs implied by stock option grants, option exercises will produce negative abnormal returns. We design and implement a stock-picking strategy based on predictions of stock-option exercise using publicly-available information. We are able to identify stocks that subsequently exhibit signicant negative abnormal returns using either a CAPM or three-factor Fama-French benchmark. We also nd weak evidence that the returns are more negative for rms whose earnings shocks are more persistent, as predicted in a recent theoretical model in which limited investor attention is the source of mispricing. More consistent with the notion of limited investor attention, we nd our results to be stronger in months where rms issue quarterly reports which alert investors to any dilution stemming from the exercise of employee stock options. 2 1 Introduction In the growing controversy over o-balance sheet liabilities and potentially inated earnings re- ports, employee stock options take pride of place (see The Economist (2000), Byrnes (2002), and Morgensen (2002)). For example, the Investor Responsibility Research Center (2001) reports that just over 14% of the equity of the average S&P 500 rm has been promised to employees through stock option plans. 1 Under current US accounting rules, stock option grants are not expensed, are not recorded on balance sheets, and are only partially reected in diluted Earnings Per Share. In 2003, Standard & Poors will introduce a new data item that it terms Core Earnings which will expense employee stock option grants using Black-Scholes values, and major rms such as Coca-Cola and General Electric have promised to do the same to their future earnings reports. 2 The controversy over how employee stock options should be treated in accounting reports has largely neglected the question of whether market prices already account for the associated costs. 3 If prices do not reect these costs, it should then be possible to devise a protable stock selection strategy based on public information. Jenkins (2002) states the case with much stronger language: Myth: Failing to deduct an expense for management stock options inated earnings
and therefore stock prices. Good grief. Weve been discussing this rule change for a decade now. It would be the overripe short-selling opportunity of the century if the
market were somehow fooled into mispricing stocks simply because we failed to adopt
a particular accounting treatment for the non-cash value of options. To formulate a test of this hypothesis, we begin with the assumption that investors eectively disregard at least a portion of the costs of stock option grants. 4 An obvious implied trading strategy is to short or downweight rms with large amounts of employee options outstanding, but this is an incomplete strategy. The unaddressed question is exactly when do investors realize the costs of options and drive prices back to fundamentals? 5 We assume that prices do not reect 1 The Economist (2000) reports that the Black-Scholes value of employee stock option grants in 1999 was just over 6% of the earnings of an average S&P 500 rm. Core and Guay (2000) document that the Black-Scholes value of
employee stock options average almost 4% of the market capitalization of the average large corporation, with values
at the upper end of the spectrum approaching 24%. Sanford F. Bernstein & Co estimates that if option grants had
been expensed, prot growth for the S&P 500 over 1997 through 2001 would drop from 9% to 6% (see Morgensen
(2002)). 2 See Standard and Poors (2002). 3 One can also interpret these costs as dilution, as the distinction between the two is semantic. Interpreting stock options as a cost to shareholders aects the expected cash ows to a rm, whereas treating them in terms of their
dilution aects the number of outstanding shares. Both interpretations result in the same price per share. The
substantive problem we analyze is that current accounting standards do not report either dilution or cost at the grant
date. 4 While our work simply posits such behavior as our starting point, Hirshleifer and Teoh (2002) show explicitly how such mispricing can stem from limited attention and processing power on the part of investors. 5 See DeLong, et al (1990) for an example of a research design that seeks to identify how quickly market mispricing is corrected. 3 option costs until they materialize upon exercise by employees. Observe that we cannot rule out temporary mispricing in which the market adjusts to reect the costs of option grants with some unspecied lag. Searching for such an eect would inevitably result in data-snooping, because in hindsight there is sure to be at least one period in which option-granting rms have lower than expected returns. Indeed, Yermack (1997) and Ittner, et al (2002) nd that rms tend to perform somewhat better than expected in the year following large option grants. Our contention is that if investors neglect option costs, there is no reason to expect any correction in the subsequent year since no additional information about the option grant will emerge. A benet of formulating the test as a trading rule is that it forces the researcher to recognize many of the constraints that an active investor would face. 6 Most importantly, we must use forecasted option exercises, rather than realized option exercises used by Carpenter and Remmers (2001) and Huddart and Lang (2002). Their research can ascertain whether executives made well- timed trades based on their own information, but it is mute on the question of market eciency unless the market is sluggish in its reaction to the revelation of an insider sale. 7 By contrast, we use public information to forecast future exercises and form our portfolios in anticipation of such exercises. This empirical strategy is most sensible for two reasons. First, the relevant data for the exact date at which employees exercise is unavailable save for the top executives in the rm. This data constraint precludes the use of an event-study methodology. Second, even if we were to use a longer estimation window, the results would be biased because employees will only exercise their options if the stock has performed well enough to make the options suciently valuable to exercise. To predict the year in which employee exercise will take place, we rely on a typical, three- year vesting schedule of employee stock options, in conjunction with results documented in existing research on the decision to exercise such options (see Huddart and Lang (1996) and Heath, Huddart and Lang (1999)). 8 We then test the more rened proposition that prices will reect exercises primarily in months where the rm issues quarterly reports; such reports alert shareholders to the net eect of stock option exercises on the rms balance sheet. 6 Core, et al (2000), Huson, et al, (2000) and Aboody, et al (2001) nd some evidence that market values of equity are lower when option liabilties are greater. While these studies are consistent with the view that stock prices already
incorporate option costs, they have limited power to reject the hypothesis of market eciency. First, the regressions
require that book value, earnings, and earnings forecasts provide an adaquate control for other determinants of value.
Perhaps as a result of potential misspecication problems, the result that option costs are reected in lower market
value does not hold in all specications. Second, the estimated eect of option costs on value is generaly less than
one-for-one. We cannot tell if this is due to error in measuring option costs or to the market only taking partial
account of stock option costs. 7 See Seyhun (1998) for an exhaustive treatment of the investment value of insider trading disclosures. 8 That is, we assume that options granted during the year 1992 will have vested by the beginning of 1996 since at least three full years will have passed. In our empirical analysis of how well our predicted exercises explain realized
exercises in a small sample (Table 4 ), we document successes for both this three-year cli-vesting schedule and the
25%-per-year vesting schedule. 4 To estimate the costs of expected option exercises, we use Standard and Poors ExecuComp data for each of the years 1992 to 1996, thereby forming our trading strategy over the years 1996 to 2000. This restricted time-series is driven by our assumption that stock options dont vest until the beginning of the fourth year after which they were granted, coupled with the fact that the ExecuComp data does not begin until 1992. Despite this limitation, we estimate a reliable and negative relationship between abnormal returns and our measure of the unrecognized cost of employee stock options. Specically, using either a portfolio alpha approach or the Fama and MacBeth (1973) method, we nd that the results are signicant at the 5% level or better for both CAPM and Fama-French abnormal returns. Moreover, we nd that the eects tend to be stronger in months when quarterly reports are issued. Obviously, our time-period is unrepresentative in that the market performed better than its historical average. However, we continue to nd evidence that the market underestimates the costs of stock options even after controlling for rm xed eects, that is, after setting each rms expected returns equal to its average realized return over our time period 1996 to 2000. The paper is organized as follows. Section 2 presents a simple model that highlights the key measurement and accounting issues, as well as the assumptions required for our trading rule to work. Section 3 summarizes our data and how we put together our stock selection rule. Section 4 analyzes the performance of our trading rule. In Section 5 we provide further evidence on Hirshleifer and Teohs (2002) model of limited investor attention. Section 6 presents our sensitivity analyses and Section 7 concludes. The Appendix contains the proof of our main proposition. 2 A Simple Model Consider an all-equity rm with n shares outstanding plus m identical employee stock options, each with an exercise price X. The present value of the rms future cash-ows is denoted by V . We consider two periods. The rst period corresponds to the time that we make our stock selections, at which point all parties agree that V = V 0 and that rm value in the second and nal period is distributed according to the distribution F (V ). In this terminal period, employees can exercise their options and will choose to do so if their options are in the money. While the results in this section hold for any distribution of terminal values, in our empirical work we will eectively assume that it is log-normal because we use the Black-Scholes-Merton formula to approximate the value of options. Denote by P 0 the stock price at the initial period and denote the stock price in the terminal 5 period by P 1 . If options expire out of the money, there will be only n shares outstanding so P 1 (out) V n . If by contrast options expire in the money, the shareholders receive a cash infusion of mX, but must also issue m additional shares, thus P 1 (in) V +mX n+m . Denote by V nX the critical terminal value of V at which the options are just at the money. This value is unique since P 1 (in) = P 1 (out) only at V = V = nX. Our interest in this paper is whether the market properly anticipates the costs of stock options, so our attention is focused on the initial price P 0 . Since the expected market rate of return is assumed zero, a price that appropriately anticipates stock option costs along with the distribution of returns simply equals the expected value of the terminal price. Since the terminal price is V n if V V and V +mX n+m otherwise, we can write the price that correctly anticipates option dilution as P 0 = V Z 0 V n dF (V ) + Z V V + mX n + m dF (V ). (1) Observe that an estimate of P 0 in our model requires knowledge of the number of options granted m and the exercise price X. In practice, these values have in fact been reported at the option grant date in footnotes of annual reports since 1992. The costs are not, however, integrated into rm earnings at the grant date, nor is the evolving liability recorded on the balance sheet. An extreme view would be that the market completely ignores stock option costs, in which case the initial price would simply be given by E(V ) n . While we present evidence consistent with this view in the empirical section, we focus on the somewhat less extreme hypothesis that investors make use of the information summarized in diluted earnings per share according to SFAS 128, but do not take account of the full costs of options. SFAS 128 requires rms to recognize an additional number of shares equal to max[0, m(P 0 X) P 0 ]; see, for instance, Core, et al (2000). Put into valuation terms, SFAS 128 assumes that if options are currently not in the money, then there is no option dilution, while if they are currently in the money, the options will be immediately exercised. 9 Following this logic we dene: P Acc 0 =
R 0 V n dF (V ) if R 0 V dF (V ) V R 0 V +mX n+m dF (V ) otherwise. (2) Clearly, the above price does not correctly incorporate the expected cost of option exercises as is done in equation (1). It either assumes that the options will never be exercised, or that they will always be exercised. Our purpose in this section is to derive the empirical implications of a 9 Currently here means at the scal year-end. For convenience, we henceforth assume that time 0 is the end of the scal year. We incorporate dierences between price at portfolio formation time and at the end of the scal
year in our empirical work. 6 world where investors are misled by the accounting treatment of stock options to systematically underestimate their cost. Formally, the model yields the following result. Proposition 1 If the initial stock price is P 0 , then the expected abnormal return on the stock is zero. However, if the initial price is P Acc 0 , the expected abnormal return is equal to mU nP 0 , where nP 0 is the rms initial market capitalization and U = R V V nX n+m dF (V ) max[0, P 0 X] is the unrecognized cost of a single employee stock option. The intuition behind this result is straightforward. If investors underestimate the expected costs of employee stock options, the expected abnormal return is clearly negative. This implica- tion is a direct consequence of our assumption that P Acc 0 eectively ignores the time value of the options. Hirshleifer and Teoh (2002) provide a model that endogenizes such a specication, and their Proposition 5 contains the analogous prediction that if some investors have limited attention and stock options are not expensed at the time they are granted, the market will overvalue rms relative to fundamental value, with greater overvaluation being associated with larger employee stock option grants. 10 An additional implication of their model that is beyond the scope of our reduced-form approach is that as the persistence of earnings increases, the greater will be the over- valuation due to employee stock options and the more negative the abnormal return will be upon exercise. We test the proposition empirically in Section 5. Proposition 1 eectively characterizes expected returns, conditioning only on the characteristics of the stock option grant (m and X). While we report results with raw returns in our empirical section, we focus on market-adjusted returns to each stock to isolate underperformance from any correlation between stock option costs and systematic risk factors. In addition to the relationship between raw and risk-adjusted returns and option values, it is also possible to estimate expected returns conditional on observing option exercise. Such a test would not address the question of whether or not the market appropriately prices the costs of employee stock options, because em- ployees will exercise only if V > V . That is, we expect to see a positive relationship between employee stock option exercises and prior stock market performance, even if investors had overval- ued the rm by neglecting the fact that employees will share in good stock price performance. 11 10 Hirshleifer and Teoh (2002) provide an opposite prediction for the situation in which the expected option costs are fully expensed at the time of granting, resulting in rms being undervalued. However, since current U.S. accounting
standards do not require such full expensing, this prediction remains untested. 11 As emphasized earlier, prior research has documented a negative relationship between option exercises and 7 We conrm this relationship empirically in our Table 3, but it is of secondary interest. The more important implication of Proposition 1 is that the stocks of rms with large amounts of expected option exercise will perform worse than they otherwise would have, and operationally this means that they will underperform their market-based benchmarks. There are two key issues that our simple two-period model does not address. The rst is the choice of the initial period. This is arbitrary in the theory. To reect accounting reality, however, we have to recognize that P Acc refers to the price at the end of the last scal year since this is the price that is used in computing the most recent version of diluted EPS. The second timing issue is the terminal point. In the model, the ending point is the date that the employees exercise their options. The contractual maturity of most employee stock options is 10 years. Thus, if employees behave according to risk-neutral option pricing, we would observe exercises before 2002 only for those rms that grant options with maturities less than 10 years and for those with extremely high dividend payouts. It is, however, well known that employees exercise grants soon after vesting if the option is in the money (see Huddart and Lang (1996) and Heath, Huddart and Lang (1999)). Indeed, SFAS 123 requires rms to disclose in footnotes (not earnings) the Black-Scholes value of option grants but leaves them free to assume maturity dates far less than the contractual maturity in so doing. Our model does not endogenize early exercise (see, e.g. Meulbroek (2001) and Hall and Murphy (2000) for models that do so based on employees lack of diversication), but the model is consistent with this practice. We interpret V as the level of rm value at which the employee chooses to exercise. In the real-world with early exercise, if the actual value at the end of a period before maturity falls below V , it does not mean that the option actually expires out of the money. Rather, it means that the option remains alive, to be potentially exercised in subsequent periods. We now turn to the construction of our stock selection rule to delineate exactly how we deal with these issues. 3 Data and the Stock-Selection Procedure 3.1 Estimating the Costs of Option Exercises Our stock selections are based on employee option information from Standard and Poors Execu- Comp, combined with market data from CRSP. ExecuComp reports key information about option subsequent stock returns, but this is most plausibly explained as reecting employees informational advantages and
does not address the question of semi-strong-form market eciency. 8 grants to executives for the S&P 1500 rms (including the S&P 500, the S&P Midcap, and the S&P Smallcap) starting in 1992. The database covers at most ve executives, but also reports the percentage of total option grants in a given year represented by a given executive option grant. 12 ExecuComp also provides summary information on options granted before 1992, but only for the top ve executives. We have no data on the scale of grants to all employees before that date. For the grant data starting in 1992, we assume that other employees have options with the same exercise price as the executives, which amounts to assuming that they receive their grants at the same time. For most rms in our sample, this is sucient. However, nearly 35% of the rms in our sample made multiple grants to the CEO and/or to other executives. We assume that employees receive grants in the same proportion as the CEO. That is, the CEOs grant is assumed to be a scale replica of the total option grant at his/her rm. Our trading rule also requires an estimate of when employees exercise their options, and the associated costs to shareholders. Huddart and Lang (1996) and Heath, Huddart, and Lang (1999) both document spikes in employee exercises at options vesting dates if they are in the money. We make our stock selections at the beginning of each year and can only use information at that time. Proposition 1 tells us that the expected negative abnormal return is just equal to the unrecognized cost of the options, scaled by the current market capitalization of the rms equity. To estimate the unrecognized cost we use the Black-Scholes-Merton value less the intrinsic value of the options at the end of the scal year. Since our selections are made for a given year, we also assume a maturity of one year in computing our Black-Scholes values. Obviously, more frequent selections would increase the power of our tests, but the underlying option data is only annual. Below, we describe two ways in which we can at least use stock price information to update our option cost estimates more frequently than once per year. Our primary rule for computing option costs is computed as follows. In 1992, we take the number, n 1992 , and exercise price of options granted, X 1992 , for each rm, and then look forward to the end of scal-year 1995. At this point we estimate the volatility for each rms stock returns using the previous ve years of monthly data. We compute the intrinsic value version of the dollar option cost as the maximum of zero and the dierence between the stock price at the end of the rms scal 1995 and the exercise price. This number, scaled by market capitalization, is 1992s contribution to diluted earnings per share computed according to SFAS 128 (see Core, Guay, and Kothari (2000)). Our forecast of the unrecognized dollar cost of options that will be realized in 1996 computes the Black-Scholes value of options granted in 1992, valued at the end of 1995, and 12 Thanks to Wayne Guay for alerting us to the presence of this data item. 9 assumes a one-year maturity. More formally, for each rm we compute U 1996 = n 1992 (C(P 1995 , X 1992 , d, , T = 1) L
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