Implications of Ex Post Estimation Error in CEO Option Grants

Abstract

Companies report two measures of CEO option pay. Grant-date fair values are initial estimates of the expected values of future option contract settlements. Payouts from exercise are realized values from option contracts settled during a year. We call the difference between cumulative grant-date fair values and payouts from exercise over a CEO’s tenure “ex post estimation error” because it represents information about factors that affect option settlements that is not available at the grant dates. Ex post estimation errors amount to 27% of cumulative grant-date fair values for ExecuComp CEOs from 1992 to 2009. We predict and find that outsider CEOs have significantly higher ex post estimation errors than insider CEOs, after controlling for CEO performance and tenure. This implies that pay comparisons based solely on grant-date values are inequitable. We test whether pay-based shareholder activism decreases with ex post estimation error but do not find that it does. This implies that shareholders may overlook information about factors that affect option settlements when making targeting decisions.