How Well Do Investors Process (More Subtle) Information? The Case of Employee Stock Options

38 Pages Posted: 20 Mar 2007 Last revised: 4 Dec 2008

See all articles by Jian Cai

Jian Cai

Washington University in St. Louis

Gerald T. Garvey

Blackrock

Todd T. Milbourn

Washington University in Saint Louis - Olin Business School

Date Written: November 14, 2008

Abstract

This paper explores the efficiency with which value-relevant information disclosed by firms makes its way into stock prices over the period 1994-2007. Specifically, we explore whether investors incorporate disclosures related to employee stock option grants into their valuations given that these options often represent a significant potential source of dilution for shareholders. It is well known that prior to June 2005, reported earnings did systematically understate the associated option costs, but an efficient stock market should show no such bias in its valuations as long as the information is accurately disclosed somewhere. If by contrast stock prices don't fully incorporate the future costs implied by stock option grants, the dilution that materializes upon exercises will produce negative abnormal returns. Since, as we confirm, it is relatively easy to forecast exercises, we can predict these negative returns if the market is less than efficient. We are able to identify stocks that subsequently exhibit significant negative abnormal returns as measured using the CAPM, 3- and 4-factor Fama-French models, as well as industry benchmarks. We also find that firms with high imminent option dilution tend to show reversals of positive returns. The evidence we uncover here is consistent with investors exhibiting both limited attention and information processing power. Buttressing this argument is the fact that our abnormal return results are partially mitigated in the sample year after the accounting change, suggesting that the form of information disclosure (here taking the form of an explicit earnings adjustment) may play a role in the efficacy of market prices.

Keywords: Stock options, dilution, limited attention, information disclosure

JEL Classification: G30, G12, G14

Suggested Citation

Cai, Jian and Garvey, Gerald T. and Milbourn, Todd T., How Well Do Investors Process (More Subtle) Information? The Case of Employee Stock Options (November 14, 2008). Available at SSRN: https://ssrn.com/abstract=972563 or http://dx.doi.org/10.2139/ssrn.972563

Jian Cai (Contact Author)

Washington University in St. Louis ( email )

Gerald T. Garvey

Blackrock ( email )

Level 37, Chifley Tower
2 Chfiley Square
Sydney, NSW 2000
Australia
+61 2 9272 2388 (Phone)

Todd T. Milbourn

Washington University in Saint Louis - Olin Business School ( email )

1 Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6392 (Phone)
314-935-6359 (Fax)

HOME PAGE: http://www.olin.wustl.edu/faculty/milbourn/

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