The Economic Dilution of Employee Stock Options: Diluted Eps for Valuation and Financial Reporting

Posted: 26 Mar 2002

See all articles by John E. Core

John E. Core

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Wayne R. Guay

University of Pennsylvania - Accounting Department

S.P. Kothari

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Multiple version iconThere are 2 versions of this paper

Abstract

In this paper, we derive a measure of diluted EPS that incorporates the economic implications of the dilutive effects of employee stock options. We show that the existing FASB treasury-stock method of accounting for the dilutive effects of outstanding options systematically understates the options' dilutive effect, and thus overstates reported EPS. Using firm-wide data on 731 employee stock option plans, our proposed measure suggests that economic dilution from options is, on average, 100 percent greater than dilution in reported diluted EPS using the FASB treasury-stock method.

We examine the implications of our analysis for stock price valuation, the price-earnings relation, and the return-earnings relation. We demonstrate analytically that when firms have options outstanding, empirical applications of equity valuation models that use reported per-share earnings as an input (e.g., Ohlson 1995) yield upwardly-biased estimates of the market value of common stock. We predict that when the difference between our measure of economic dilution from options and the FASB treasury-stock method dilution from options is greater, the observed return-earnings and price-earnings coefficients will be smaller, and we provide some (albeit weak) empirical support for this prediction.

Keywords: Employee stock options, Dilution, Diluted earnings per share, Earnings response coefficients, Equity valuation

JEL Classification: G12, M41, M44, M45

Suggested Citation

Core, John E. and Guay, Wayne R. and Kothari, S.P., The Economic Dilution of Employee Stock Options: Diluted Eps for Valuation and Financial Reporting. Available at SSRN: https://ssrn.com/abstract=303659

John E. Core

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02138
United States

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)

S.P. Kothari

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

E52-325
Cambridge, MA 02142
United States
617-253-0994 (Phone)
617-253-0603 (Fax)

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

Paper statistics

Abstract Views
4,302
PlumX Metrics