Earnings Dilution and the Explanatory Power of Earnings for Returns
The Accounting Review Vol. 76, No. 4, October 2001
Posted: 26 May 2013 Last revised: 30 May 2013
Date Written: October 1, 2000
Executive stock options and convertible securities can increase the number of common shares outstanding while adding less than the market value of the newly issued securities to a ﬁrm’s assets. We model the effect of expected dilution on the earnings/return relation. Expected dilution effectively reduces the permanence of an earnings innovation. Empirical evidence supports the hypothesis that dilutive securities attenuate the relation between earnings and returns. Estimated earnings response coefﬁcients (ERCs) are signiﬁcantly lower when there are shares reserved for conversion. The effect is more pronounced for ﬁrms that have experienced price increases or positive earnings news, as these increase the expected dilutive effect of conversions.
Keywords: stock options, dilution, earning, stock returns
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