The Pricing of Mismeasured EPS

Abstract

GAAP EPS requires different methods to measure potential dilution effects for stock-based compensation and convertible instruments. Both methods fail to reflect an economic assessment of dilution. This study examines whether common stock prices reflect an economic, rather than accounting, measurement of dilution. It also examines whether this association varies with information processing benefits and costs. It provides evidence suggesting investors impound economic dilution into prices on average, rather than relying on GAAP dilution alone. It also provides evidence consistent with it only being cost-beneficial for investors to impound economic dilution into prices when information processing benefits are high or information processing costs are low. Short-window stock price reactions to stock-based compensation dilution information in 10-K releases corroborate this finding. Overall, results suggest that standard setters consider whether improvements to either EPS dilution measurement or disclosure to lower information processing costs for users assessing economic dilution are warranted. 

JEL Classification: G10, G14, M41