Are Executive Stock Options Associated with Future Earnings?

Abstract

We estimate the relation between top 5 executive stock option (ESO) grants and future earnings to examine whether incentive alignment or rent extraction by top managers explains option granting behavior. The future operating income associated with a dollar of Black-Scholes value of an ESO grant is $3.82. To understand the source of these positive payoffs, we parse out ESO grant value into components predicted by economic determinants of option grants, governance quality, and a residual grant value. The payoffs to ESOs appear to be driven predominantly by the economic determinants of ESO grants and not poor governance quality. Thus we find little evidence in support of rent extraction.

Keywords: management compensation, stock options, incentive alignment, rent extraction

JEL Classification: G30, J33, M41