Discussion of: Real Investment Implications of Employee Stock Option Exercises

Posted: 11 Mar 2002

See all articles by Wayne R. Guay

Wayne R. Guay

University of Pennsylvania - Accounting Department

Multiple version iconThere are 2 versions of this paper

Abstract

Some practitioners and academics believe that firms can reduce earnings-per-share (EPS) dilution from employee stock option exercises by repurchasing shares. Academic studies in this area are motivated with some combination of the following assumptions about managerial behavior: 1) managers believe employee stock options "dilute" EPS; 2) managers believe share repurchases mechanically increase EPS; 3) managers and/or investors myopically focus on short-term EPS; 4) firms have severe cash constraints and high financing costs that force managers to fund EPS-motivated share repurchases with cash diverted from alternative investment opportunities. This discussion challenges the economic underpinnings of these arguments in the context of a recent paper by Bens, Nagar and Wong (2001) that investigates whether firms repurchase shares with cash diverted from profitable investment expenditures in an attempt to mitigate EPS dilution from employee stock option exercises. Specifically, this discussion suggests that there is reason to believe all of the four key assertions listed above are either incorrect or tenuous.

The intuition for why employee stock options are unlikely to dilute EPS is based on theory and empirical evidence that granting options to employees is conceptually similar to raising capital through issuing stock. Employees receive stock options as an equity stake in the corporation in return for services rendered. Like any other factor in production, corporations use these employee services to earn profits. As such, stock options are not expected to be any more dilutive than other forms of equity finance, such as common stock and most stock-based securities (e.g., convertible debt, warrants, convertible preferred stock) that contribute to the shares used to compute the denominator of EPS. In fact, because employee stock options are not expensed in earnings, one can argue that they dilute EPS to a lesser extent than other forms capital. Whether share repurchases mechanically increase EPS depends on whether the foregone return on cash used for repurchases is less than or greater than the ratio of the firm's earnings to the market value of equity (i.e., the earnings-to-price ratio). Given that earnings-to-price ratios have been in the 0.02-0.05 range for most firms in recent years, it is reasonable to expect that share repurchases actually decrease EPS for the majority of firms. Finally, the question of whether EPS-motivated share repurchases cause firms to divert cash from alternative investment opportunities requires the existence of severe cash constraints and high financing costs and/or the widespread absence of rational expectations on the part of management, conditions that are unlikely to be met for many firms that are accused of this practice.

Keywords: Employee stock options; Share repurchases; Earnings per share; Payout policy; Investment; Capital expenditures; Corporate finance

JEL Classification: G30, G31, G32, G35, J33, M40, M41, M46

Suggested Citation

Guay, Wayne R., Discussion of: Real Investment Implications of Employee Stock Option Exercises. Available at SSRN: https://ssrn.com/abstract=303639

Wayne R. Guay (Contact Author)

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
1329 Steinberg-Dietrich Hall
Philadelphia, PA 19104-6365
United States
215-898-7775 (Phone)
215-573-2054 (Fax)

Do you have negative results from your research you’d like to share?

Paper statistics

Abstract Views
2,278
PlumX Metrics