Stock option compensation and equity valuation

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Date

2002

Authors

Li, Haidan

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Abstract

This dissertation provides a theoretical analysis and empirical investigation of the valuation implications of employee stock options. First, I modify the residual income model for stock valuation in the presence of employee stock options. I identify two distinct roles of employee stock options in valuation: current outstanding employee options and stock options expected to be issued to compensate employees in future periods. The value obtained from traditional residual income models must be adjusted for the value of outstanding options. In addition, the value of expected future employee stock options must be explicitly incorporated into the traditional residual income models when firms do not expense the fair value of options in net income. Based on the analytical results, empirical tests are conducted to provide evidence on whether the effects of employee stock options are reflected in share prices. The results support the existence of a cross-sectional negative association between share prices and both outstanding employee options and expected stock option expense. The findings are consistent with the modified residual income model in which outstanding employee options and expected stock option expense have distinct valuation effects. In addition to the association tests for the relation between share prices and information about employee options, I conduct event studies which provide evidence that SFAS No. 123 footnote disclosures communicate useful information about employee stock options to investors. Specifically, I find a negative association between unexpected stock returns and changes in stock option expense disclosed under SFAS No. 123 around firms’ 10-K filings with the SEC. Taken together, the results from both the association study and the event study suggest that investors adjust share prices for the potential dilution caused by outstanding employee stock options, and recognize to some extent the compensation expense associated with stock option compensation.

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