The Relationship between Employee Stock Options and Stock Repurchases
Research by Daniel A. Bens and M. H. Franco Wong
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. Recent 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
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 go up.
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
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 University
of Chicago Graduate School of Business professors Daniel A.
Bens and M. H. Franco Wong.
In the late 1990s, when employee stock options increased,
corporate managers began to repurchase large shares of their
own stock. In their recent study, "Employee Stock Options,
EPS Dilution, and Stock Repurchases," Bens and Wong,
along with Douglas J. Skinner 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 increases 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 firm value.
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
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.
In addition, managerial incentives may cloud the company's
"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 S&P 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 of EPS.
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," says Bens.
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
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.