The Pricing of Mismeasured EPS Under the If-Converted Method

61 Pages Posted: 23 Aug 2019

See all articles by Clay Partridge

Clay Partridge

University of Wisconsin - Madison, Students

Date Written: August 18, 2019

Abstract

GAAP potentially mismeasures diluted EPS in two ways in the presence of convertible instruments - debt or preferred stock. First, GAAP treats certain convertible instruments that are not likely to convert as if they will convert. Second, GAAP treats certain convertible instruments that are likely to convert as if they will not convert. In both cases, GAAP understates diluted EPS. I examine whether and under what conditions investors incur the information costs necessary to reflect the accounting mismeasurement of diluted EPS in common equity prices. I provide evidence that suggests, on average, that investors do. However, the association between common equity prices and accounting mismeasurement of the economic conversion effects varies with the magnitude of the measurement error, as a proxy for benefit of information, and/or analyst coverage, as a proxy for the information environment. This evidence suggests investors partially process accounting mismeasurement of diluted EPS.

Keywords: diluted EPS, convertible debt, convertible preferred stock, information costs, if-converted method

JEL Classification: G10; G14; M41

Suggested Citation

Partridge, Clay, The Pricing of Mismeasured EPS Under the If-Converted Method (August 18, 2019). Available at SSRN: https://ssrn.com/abstract=3439091 or http://dx.doi.org/10.2139/ssrn.3439091

Clay Partridge (Contact Author)

University of Wisconsin - Madison, Students ( email )

716 Langdon Street
Madison, WI 53706
United States

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