|
Article Excerpt
I. INTRODUCTION
Firms use employee stock options more frequently and in larger quantities than they did two decades ago. The median number of shares reserved for stock options as a percentage of shares outstanding for all firms on Compustat increased monotonically from 4.6 percent in 1985 to 8.9 percent in 1995. In our sample, options outstanding (which is a subset of shares reserved for options) grows monotonically from 5.3 percent of shares outstanding at December 1994 to 6.1 percent at December 1997. This growth has drawn scrutiny from members of the investment community, including individual and institutional shareholders, analysts, standard setters, and regulators, many of whom are concerned that diluted earnings per share (EPS) understates the effect of stock options on corporate performance (e.g., see The Economist 1999).
As a summary assessment of a corporation's current performance, the EPS number and forecasts of expected EPS are central to fundamental analysis, equity valuation, and performance evaluation. Investors, analysts, and regulators have at least two concerns about the economic impact of employee stock options on EPS. First, what is the appropriate charge to earnings for compensation expense associated with newly granted employee stock options? That is, what is the appropriate numerator in the EPS calculation? Second, how much of a firm's earnings accrues to holders of outstanding options? That is, what is the appropriate denominator in the EPS calculation such that diluted EPS reflects current performance per unit of common equity?
In this paper, we focus on the proper measurement of the denominator in the EPS calculation and provide theoretical and empirical evidence that diluted EPS, when computed using the FASB treasury-stock method, underestimates the economic dilutive effects of outstanding options. (1) Intuitively, the expected future stream of economic earnings drives the total value of a firm's equity, which includes outstanding common stock and options-based equity. That is, both current optionholders and current stockholders have economic claims on the firm's earnings, and the two sets of claimholders share the capitalized value of these earnings. We argue that any diluted EPS measure that summarizes firm performance per unit of common stock must reflect the claim on firm earnings that accrues to outstanding optionholders, and we show that the FASB treasury-stock method fails to achieve this objective.
We begin our theoretical analysis by noting that total equity value is the sum of common stock value and the value of total outstanding options. We use this relation to allocate earnings between stockholders and optionholders, and then scale the earnings allocated to stockholders to obtain a measure of options-diluted EPS that reflects the per-share claim common stockholders have on the firm's earnings. We show that our theoretical measure of option dilution is substantially greater than option dilution computed using the FASB treasury-stock method. We then derive the relation between changes in earnings and stock returns, and show that the portion of equity value change captured by optionholders is a function of the sensitivity of outstanding options to a change in stock price (i.e., the option delta). We illustrate theoretically that estimated return-earnings and price-earnings coefficients are expected to be smaller, the greater the difference between our measure of dilution from options and FASB treasury-stock method dilution from options.
Our empirical analysis indicates that FASB-diluted EPS systematically underestimates the dilutive effect of employee stock options. In a sample of 731 large firms over the period 1994-1997, the average economic dilution due to stock options (estimated using our method) is equivalent to 2.96 percent of weighted average common shares outstanding. In contrast, the average dilution due to stock options computed using the FASB treasury-stock method is only 1.46 percent of weighted average common shares outstanding. For intensive users of stock options, such as high-growth firms, the difference between our estimate of economic dilution and FASB treasury-stock method dilution is as much as 8 percent of weighted average common shares outstanding. Our empirical evidence on the return-earnings and price-earnings relation provides weak support for our hypothesis that earnings response coefficients estimated using FASB-diluted EPS have greater downward bias as error in the FASB treasury-stock method increases.
Our theoretical analysis has implications for stock price valuation, the price-earnings relation, and the return-earnings relation. For example, our findings highlight that empirical applications of Ohlson's (1995) residual income valuation model using FASB-diluted earnings to estimate per-share stock valuation are misspecified, particularly for relatively intensive users of stock options. The misspecification arises because these models inadequately address the sharing of equity value with optionholders in calculating earnings per share. For some sample firms with large option plans, the value of options outstanding is approximately 10 percent of the market value of common stock. For these firms, ratios of observed share price to estimated fundamental value (calculated using the residual income model applied to FASB-diluted EPS) are understated by about 10 percent, and empirical estimates of the equity risk premium as in Gebhardt et al. (2001) are overstated. Although Ohlson (2000) is pessimistic about the validity of empirical applications of the residual income model for firms that issue stock options, we offer a means of correcting for this misspecification with a deflator that varies with the characteristics of firms' option plans.
Our paper also provides insights for policymakers and accountants concerned with developing a measure of reported diluted EPS that captures the economic dilution from options accurately. Because the FASB treasury-stock method systematically understates the dilutive effects of outstanding options, thereby biasing FASB-diluted EPS upward, this accounting treatment is aggressive, and is neither unbiased nor conservative. In contrast to the FASB-diluted EPS, our measure of options-diluted EPS is consistent with the stated SFAS No. 128 (FASB 1997) objective to produce an EPS number that reflects the effect of dilutive securities.
In related research, Huson et al. (2001) use a sample of firms from 1970 to 1995 and document that the stock return response to changes in accounting income is smaller for firms with more shares reserved for conversion. (2) They also show that the return-earnings response is smaller for firms with higher recent returns, where recent returns proxy for the extent to which options and convertible securities are in the money. Their empirical evidence is consistent with (1) optionholders and other convertible securityholders having a claim on firms' earnings; (2) this claim being proportionately greater when the options and convertibles are further in the money; and (3) the market reflecting the dilution of options and convertibles in stock prices. We extend and formalize Huson et al. (2001) by deriving a method that partitions earnings between stockholders and optionholders based on their relative economic claims. As explained above, we use this method to calculate a measure of options-diluted EPS that is appropriate for both valuation and (potentially) financial reporting. We also identify the nature and source of deviation between our measure of options-diluted EPS and FASB-diluted EPS. Using detailed, hand-collected data on stock option plans for a sample of firms from 1994 to 1997, we document the degree to which FASB-diluted EPS understates stock options' dilutive effect, and provide (weak) evidence that, compared to our theoretical measure of options-diluted EPS, FASB-diluted EPS yields downward-biased estimates of earnings-response coefficients.
Section II explains both the FASB treasury-stock method of computing options' dilution in FASB-diluted EPS and our method of adjusting diluted EPS to account for the economic dilutive effect of options. Section III describes sample selection and presents descriptive statistics on the sample firms' option plans. In Section IV, we compare the reported and economic dilutive effects of stock options, and examine whether stock prices and returns reflect the economic dilutive effect of options. We summarize the paper and discuss its implications in Section V.
II. COMPUTING OPTIONS-DILUTED EPS
In this study, we focus on the dilutive effects of employee stock options, and abstract from diluted EPS reporting and valuation issues related to convertible debt, convertible preferred stock, and warrants. In our sample, stock options account for more than 80 percent of all dilutive shares, so we expect the dilutive effects of other convertible securities to be of secondary importance, at least on average. Ninety-four percent of our firms report dilution from stock options, but only 20 percent of our firms report dilution from convertible debt and preferred stock. Further, because the FASB requires the if-converted method to incorporate the dilutive effects of convertible debt and preferred stock into diluted EPS, an analysis of the dilutive effects of these securities is substantially more complex than for stock options. (3)
In the following subsection, we summarize SFAS No. 128 accounting rules for calculating FASB-diluted EPS using the FASB treasury-stock method. Second, we use a price-earnings model to develop a measure of EPS that reflects the economic dilutive effects of employee stock options. We go on, in the third subsection, to operationalize the measure of options-diluted EPS for explaining returns. The fourth subsection compares our measure of options-diluted EPS to FASB-diluted EPS, and discusses the implications of the differences between these measures.
FASB-Diluted EPS under the FASB Treasury-Stock Method
SFAS No. 128 states that the objective of diluted EPS is to measure entity performance over the reporting period while recognizing the dilutive effect of all securities convertible into common stock that were outstanding during the period. Both SFAS No. 128 and Accounting Principles Board Opinion No. 15 (AICPA 1969) require firms to use the FASB treasury-stock method. Under this method, the dilutive shares due to (in-the-money) stock options equals the difference between the number of common shares that would be issued upon exercise of the options and the number of common shares that can be purchased with the proceeds from option exercise. In other words, the FASB treasury-stock method calculates options' dilutive effect using the intrinsic value of an option, which is the difference between the share price and the exercise price of the option. If all of a firm's options have the same exercise price, then the dilutive shares due to options are:
Treasury-stock method dilutive shares from options = [N.sub.O] max[0,(P - X)/P]
where:
[N.sub.O] = the number of options outstanding;
P = price per share of the firm's common stock; and
X = exercise price of each option. (4)
We refer to diluted EPS calculated using the treasury-stock method as FASB-diluted EPS.
When the firm's only outstanding dilutive securities are options, we define FASB-diluted EPS as follows:
(1) FASB diluted EPS = E/([N.sub.S] + [N.sub.O][(P - X)/P]) = E/[D.sub.FASB]
where:
E = total earnings, and
[N.sub.S] = the weighted number of common shares outstanding.
We define [D.sub.FASB] as the denominator [[N.sub.S] + [N.sub.O]((P - X)/P)] that transforms total earnings E into FASB-diluted EPS.
The Effect of Options on the Relation between Stock Prices and Earnings
To derive an EPS measure that incorporates the economic dilutive effects of stock options (options-diluted EPS), we assume that equity value is a function of current economic earnings, E:
(2) [V.sub.equity] = [V.sub.equity](E).
This valuation form is quite general and is a transformation of the dividend-discount model of equity valuation (e.g., Williams 1938; Gordon 1962; Fama and Miller 1972; Collins and Kothari 1989; Ohlson 1995). When the firm has outstanding options that can be converted into common stock, the value of equity is the sum of common stock value and option value:
(3) [V.sub.equity](E) = [V.sub.stock](E) + [V.sub.options](E) = P[N.sub.S] + O[N.sub.O] = P[N.sub.S] + [N.sub.O](O/P)]
where:
[V.sub.stock] = value of the firm's common stock;
[V.sub.options] = value of the firm's outstanding options; and
O = value per outstanding option.
We re-express Equation (3) as the per-share value of the common shareholders' equity:
(4) P = [V.sub.equity](E)/[N.sub.S] + [N.sub.O](O/P).
We operationalize Equation (4) to construct a diluted EPS measure...
|
