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

44 Pages Posted: 27 Oct 1999

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

Date Written: December 2001

Abstract

We derive a measure of diluted EPS that incorporates 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 dilutive effect of stock options, and thereby overstates reported EPS. Using firm-wide data on 731 employee stock option plans, we find that economic dilution from options in our proposed measure of options-diluted EPS is, on average, 100% 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 observed return-earnings and price-earnings coefficients are expected to be smaller the greater the difference between our measure of economic dilution from options and FASB treasury-stock method dilution from options, and provide weak empirical support for this prediction.

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 (December 2001). Available at SSRN: https://ssrn.com/abstract=183068 or http://dx.doi.org/10.2139/ssrn.183068

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)

Register to save articles to
your library

Register

Paper statistics

Downloads
2,356
Abstract Views
10,177
rank
5,534
PlumX Metrics