The Relationship between Employee Stock Options and Stock Repurchases Research by Daniel A. Bens, M.H. Franco Wong, and Douglas
In the late 1990s, the use of employee stock options increased
dramatically, as did the use of stock repurchases. Both affect
a company's earnings per share. New research goes beyond the
anecdotes to determine whether financial reporting incentives
affect corporate managers' decisions to repurchase their company's
While the intricacies of corporate accounting may be puzzling
at best, the advanced statistics basically boil down to reporting
how much a company earned and what factors affected those earnings.
There are two ways to calculate a company's earnings: basic
earnings per share (EPS) and diluted earnings per share. To
derive basic earnings per share, a company takes the amount
of its earnings divided by the average number of common shares
outstanding throughout the year. Diluted earnings per share,
which will be lower than basic EPS, take into account all securities
which can one day be converted into regular shares of the company.
These convertible securities include warrants, convertible debt,
and employee stock options.
In the late 1990s, employee stock option plans became an extremely
popular way for companies to compensate their employees. These
stock options usually form the largest percentages of a company's
convertible securities. As a compensation tool, employee stock
options make it easier for companies to pay their employees
without expending cash and reducing earnings. When employees
have the option of becoming shareholders of the company, the
logical conclusion is that they will be more invested in seeing
the company succeed and work harder to make the stock price
Generally accepted accounting principles require firms to report
basic EPS and diluted EPS. As a company issues more employee
stock options, its earnings per share will become more diluted.
Investors and financial analysts use diluted earnings per share,
rather than basic earnings per share, as a measure of performance
because there are other people besides existing shareholders
who can claim a piece of the pie, note Daniel A. Bens, an associate
professor at the University of Chicago Graduate School of Business,
and M.H. Franco Wong, an assistant professor at the University
of Chicago Graduate School of Business.
In the late 1990s, when employee stock options increased, corporate
managers began to repurchase large shares of their own stock.
In their new study, "Employee Stock Options, EPS Dilution,
and Stock Repurchases," Bens and Wong, along with Douglas
J. Skinner, a visiting professor at the University of Chicago
Graduate School of Business, and Venky Nagar of the University
of Michigan Business School, investigate whether corporate managers'
stock repurchase decisions are affected by their incentives
to manage diluted earnings per share.
Managers have substantial discretion to time their firm's stock
repurchases, which increase diluted EPS. The authors sought
to identify if and when firms were repurchasing their own shares
to manage diluted EPS, and whether employee stock options played
a role in these decisions. The issue is especially pertinent
since repurchases are often portrayed as being good for the
company. However, the authors argue that repurchases for the
purpose of managing diluted EPS should have no real effect on
The authors find that managers increase the level of their
firm's stock repurchases to offset the effects of securities
such as employee stock options, which can decrease diluted EPS.
Numerous articles in the financial press have suggested that
managers repurchase shares to offset EPS dilution in response
to employee stock option plans, and executives acknowledge that
their decisions to issue and repurchase shares are influenced
by potential earnings per share effects.
The authors also find that managers increase their firm's stock
repurchases when earnings fall short of the level required to
maintain the past growth rate of diluted EPS. This finding suggests
that some EPS growth cannot be attributed to improved firm performance,
but rather repurchase activity.
The study controls for several other motives often cited for
repurchases including distributing excess cash flow, signaling
to offset perceived undervaluation, and releveraging the firm.
While stock repurchases may temporarily boost diluted EPS,
these actions do not create any value for shareholders.
"Repurchasing your own stock for this purpose is like
taking money from your left pocket and moving it to your right
pocket," says Wong.
Bens adds, "The cash managers are using to buy back shares
could have been put to better use. If there is no upside to
repurchases to offset this dilution, and there is a potential
downside, why do it?"
Managing Diluted EPS
Understanding stock repurchases requires understanding the
incentives of managers. Managers are concerned about diluted
EPS for the same reasons they are concerned about reported earnings.
Investors tend to reward firms that report consistent earnings
growth, meet analysts' earnings forecasts, and avoid earnings
disappointments. However, using cash to repurchase shares means
either reducing the firms' investments or increasing its borrowing,
both of which reduce future earnings.
Part of the curiosity of a company repurchasing its own shares
is the fact that such behavior does not create value for shareholders,
though on the surface it raises the earnings per share.
Managerial incentives may cloud the company's larger goals.
"Though some managers just want a short-term gain, we
ideally want managers to care about the long term," says
Wong. "If managers want to maximize long-term shareholder
gain, there is no point wasting time and money to buy back shares
in an effort to manage employee stock option dilution."
To clarify the underlying relationship between employee stock
options and stock repurchase decisions, the authors used annual
data for 357 firms classified as Standard & Poors 500 Industrial
firms for the years 1996 to 1999. They hand-collected data on
total employee stock options outstanding for these firms as
well as actual share repurchases per year.
Using each company's Form 10-K, the authors collected detailed
data on employee stock options, and then calculated the dilutive
effect of employee stock options on earnings per share.
Stock repurchases during the sample period averaged $301 million
per year. The same firms granted an average of 28 million options
per year to their employees, who in turn exercised 6.5 million
options per year. On average, firms repurchase
2 percent of their shares outstanding each year, while employees
exercise options representing 1 percent of shares outstanding.
After controlling for many other determinants of repurchases,
the authors find that on average, firms repurchase 0.2 percent
of shares outstanding for every 1 percent increase in the number
of potentially dilutive common shares. In addition, the authors
find that when earnings-the numerator of EPS-fails to grow at
the historical growth rate, firms increase their repurchases
by over 1 percent of shares outstanding to affect the denominator
While previous research has addressed other rationales for
stock repurchases, the study is the first to measure the real
accounting effects of employee stock options.
"Our research shows that the reason stock repurchases
increase is not because of employee stock options per se, but
rather because managers attempt to adjust for the dilutive effects
of these options by managing diluted earnings per share,"
Controlling for a number of alternate explanations, the results
indicate that managers' repurchase decisions are driven partially
by financial reporting incentives. The authors support the general
view that accounting rules have economic consequences, in this
case through their effect on managers' stock repurchase decisions.
While they are not opposed to stock repurchasing, Bens and
Wong caution that the logic behind these repurchase decisions
is not especially sound.
"Investors should be aware of how much managers are repurchasing
to manage earnings per share," says Bens. "As a manager,
I would be aware that it's a fool's game. You are not really
creating value, but a lot of managers behave like they are."
The stock market may seem to reward these repurchase decisions
with an increased stock price, but that should not be a reason
for buying back stock if it has only a short-term effect. Bens
notes that increasing a firm's stock price through repurchases
is very different from true value-enhancing strategies such
as finding new customers for the firm.
In addressing the larger issue of corporate governance, Wong
notes: "The message for the board of directors is to keep
its eyes open as to why managers want to buy back shares. Make
sure the managers are not wasting time trying to buy back shares
to manage earnings per share."
Daniel A. Bens is associate professor of accounting at the
University of Chicago Graduate School of Business. M.H. Franco
Wong is assistant professor of accounting at the University
of Chicago Graduate School of Business. Douglas J. Skinner is
visiting professor of accounting at the University of Chicago
Graduate School of Business.