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

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.