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RESEARCH: Alternative explanations for the association between market values and stock-based compensation expenditure - 25 March 2010




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aSchool Of Accounting, University of Technology, Sydney, Australia

Received 25 March 2008; 
revised 10 September 2009; 
accepted 11 September 2009. 
Available online 27 September 2009.

Abstract

The relation between stock-based compensation and market values has been tested previously in the literature, but the empirical findings are inconsistent: both negative and positive relations have been documented. The objective of this study is to provide an explanation for why both negative and positive relations between stock-based compensation expenditure and market values can be consistent with rational markets.

We argue that stock-based compensation can be used either as a reward for past performance or as an incentive for future performance. We predict that there is a negative relation to market values when stock-based compensation is granted primarily as a reward to chief executives for past performance, while there is a positive relation when stock-based compensation is used to provide incentives for enhanced future performance. This prediction is tested on a sample of 259 firm-year observations for the period 1999–2004 using an instrumental variables approach, where the sample is classified into the ‘reward’ and ‘incentive’ groups on the basis of prior period performance and option characteristics. Our findings are that there is a positive association between stock-based compensation expenditure and market values for the ‘incentive’ group, but we find overall an insignificant relation for the ‘reward’ group. A number of sensitivity tests confirm the main findings.

Keywords: Stock-based compensation; Market values

JEL classification codes: J33; G34

Table 1.

Sample selection.

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Table 2.

Firm and option characteristics that determine whether the primary motivation for granting options is for reward or incentive purposes.

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Table 3.

Descriptive statistics.

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ASSETSt, book value of total assets, $’000; EQUITYt, book value of total equity, $’000; REVENUEt, total operating revenue, $’000; MVEt, market value of equity (calculated as average share price for 3 months after year end multiplied by number of shares outstanding), $’000; OPATt, total operating profit after tax, $’000; OPATt−1, total operating profit after tax (t − 1), $’000; TOTAL_COMPt, total CEO compensation, $’000; SHARESt, number of common shares outstanding as at year end, $’000; ROAt, return on assets; ROEt, return on equity; AB_PERFt−1, abnormal performance (t − 1), calculated using Market Model; MKT_BKt−1, market-to-book ratio (t − 1); ROAt−1, return on assets (t − 1).



Table 4.

Correlation matrix – all changed in this and following tables.

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P, average price per share for three months after year end; BVE, book value of equity per share; NI, net income per share; PREDOPT, estimated options value per share from 2SLS regression; OPTBS, options value per share measured using the Black–Scholes model; OPT25%, options value per share, calculated as 25% of exercise price × no. of options granted.

low 
asterisk Significant at the 10% level (2-tailed).
low 
asterisklow 
asterisk Significant at the 5% level (2-tailed).
low 
asterisklow 
asterisklow 
asterisk Significant at the 1% level (2-tailed).


Table 5.

Summary of the OLS regression coefficients for the relation between share price and option value measured using the Black–Scholes valuation model (pooled sample). The coefficients are based on the following equation: Pit=α1it+α2BVEit+α3NIit+α4OPTit+σit.

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Pit, average price per share for three months after year end; BVEit, book value of equity per share; NIit, net income per share; OPTit, options value per share, measured using the Black–Scholes model.

low 
asterisk Significant at the 10% level (2-tailed).
low 
asterisklow 
asterisk Significant at the 5% level (2-tailed).
low 
asterisklow 
asterisklow 
asterisk Significant at the 1% level (2-tailed).


Table 6.

Summary statistics from the OLS regression of Black–Scholes option value on instrumental variables (pooled sample). The coefficients are based on the following equation: OPTit=β1it+β2VOLit+β3LIFEit+β4INTit+β5DIVit+β6NOPTit+β7BVEit+β8NIit+υit.

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OPTit, options value per share, measured using the Black–Scholes model; VOLit, share price volatility – % (for firm i at time t); LIFEit, vesting period – grant date till vesting date in years (for firm i at time t); INTit, risk-free interest rate – % (for firm i at time t); DIVit, expected dividend yield (for firm i at time t); NOPTit, number of options granted per share (for firm i at time t); BVEit, book value of equity per share; NIit, net income per share.

low 
asterisklow 
asterisklow 
asterisk Significant at the 1% level (2-tailed).


Table 7.

Summary of the 2SLS regression coefficients for the relation between share price and option value measured using an instrumental variables approach (pooled sample and by year). The coefficients are based on the following equation: Pit=γ1it+γ2BVEit+γ3NIit+γ4PREDOPTit+εit.

View table in article

Pit, average price per share for three months after year end; BVEit, book value of equity per share; NIit, net income per share; PREDOPTit, estimated options per share, value from 2SLS regression.

low 
asterisk Significant at the 10% level (2-tailed).
low 
asterisklow 
asterisk Significant at the 5% level (2-tailed).
low 
asterisklow 
asterisklow 
asterisk Significant at the 1% level (2-tailed).


Table 8.

Distribution of firms across reward and incentive groups based on prior period abnormal performance.

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Prior period abnormal performance = prior period firm-specific stock return measured using the Market Model.



Table 9.

Summary of the 2SLS regression coefficients for the relation between share price and option value (prior period abnormal performance). The coefficients are based on the following equation: Pit=γ1it+γ2BVEit+γ3NIit+γ4PREDOPTit+εit.

View table in article

Pit, average price per share for three months after year end; BVEit, book value of equity per share; NIit net income per share; PREDOPTit, estimated options per share, value from 2SLS regression.

low 
asterisk Significant at the 10% level (2-tailed).
low 
asterisklow 
asterisk Significant at the 5% level (2-tailed).
low 
asterisklow 
asterisklow 
asterisk Significant at the 1% level (2-tailed).


Table 10.

Distribution of firms across reward and incentive groups based on option exercise price.

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Discount, option exercise price is less than the firm’s share price on grant date; FMV, option exercise price equals the firm’s share price on grant date; Premium, option exercise price is greater than the firm’s share price on grant date.



Table 11.

Summary of the 2SLS regression coefficients for the relation between share price and option value (option exercise price). The coefficients are based on the following equation: Pit=γ1it+γ2BVEit+γ3NIit+γ4PREDOPTit+εit.

View table in article

Pit, average price per share for three months after year end; BVEit, book value of equity per share; NIit, net income per share; PREDOPTit, estimated options per share, value from 2SLS regression.

low 
asterisk Significant at the 10% level (2-tailed).
low 
asterisklow 
asterisk Significant at the 5% level (2-tailed).
low 
asterisklow 
asterisklow 
asterisk Significant at the 1% level (2-tailed).


Table 12.

Subsequent performance of firms, groups based on exercise price splits.

View table in article

ROA, return on total average assets; ROE, return on total average equity; EPS, earnings per share; AB_PERF, abnormal performance, calculated using Market Model.

low 
asterisk Significant at the 10% level (2-tailed).
low 
asterisklow 
asterisk Significant at the 5% level (2-tailed).
low 
asterisklow 
asterisklow 
asterisk Significant at the 1% level (2-tailed).

Corresponding author. Address: School of Accounting, University of Technology, Sydney, P.O. Box 123, Broadway, NSW 2007, Australia. Tel.: +61 612 9514 3592; fax: +61 612 9514 3669.


aSchool Of Accounting, University of Technology, Sydney, Australia
Received 25 March 2008; 
revised 10 September 2009; 
accepted 11 September 2009. 
Available online 27 September 2009.
Alternative explanations for the association between market values and stock-based compensation expenditur

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