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Linking Executive Option Stock Grants to Future Firm Performance

9/16/2003 --

ANN ARBOR, Mich.---During the boom times of the 1990s, executive stock option (ESO) grants became the fastest growing component of top management compensation. However, there is still no consensus on the relation between employee stock option compensation and future firm performance.

Advocates argue that options are granted to reduce the moral-hazard problem that stems from senior managers owning very little of the firms they manage. Financial economists holding this "incentive alignment" perspective suggest that contracts can align managers' incentives with those of shareholders. Equity ownership by managers of publicly traded companies with dispersed ownership, they say, improves performance and maximizes firm value.

Opponents, including shareholder-rights activists and organized labor, contend senior managers control the pay-setting process and compensate themselves in excess of the optimal level for shareholders. The excess pay constitutes "rent" and potentially provides a means for abusing option grants. Economists holding this view, known as the "rent extraction" perspective, say stock options do not necessarily produce the desired economic results and may even be a politically expedient way of cloaking senior managers' pay.

To better understand the overall net payoff to granting ESOs, Michelle Hanlon of the University of Michigan Business School and Shiva Rajgopal and Terry Shevlin of the University of Washington Business School studied the stock options granted to the top five executives at 1,965 companies from 1993 to 2000. They also looked at the ESO payoffs at 1,069 of the firms from 1998 to 2000. Future earnings were measured by operating income.

Their findings show a markedly positive relation, on average, between ESO grants and future earnings. In fact, the future operating income associated with a dollar of an ESO grant is, on average, $3.82. The results, forthcoming in the Journal of Accounting and Economics, reaffirm the incentive-alignment perspective and offer little evidence in support of the rent-extraction viewpoint.

Hanlon, an assistant professor of accounting at the Michigan Business School, and her co-authors further investigate the source of the positive payoffs by looking at the reasons for granting stock options. They find that firms with greater growth prospects, greater investment opportunity sets, riskier earnings streams, higher cash compensation levels and dividend (but not cash) constraints appear to grant a higher level of stock options.

However, firms where corporate governance can be classified as poor do not grant a greater number of options, according to the researchers, who then use this information to parse out the source of the positive payoffs to stock option grants.

"It appears as though firms with greater economic incentives to grant stock options, such as high growth prospects, dividend constraints and investment opportunity sets, grant more options, and such firms perform well in the future," Hanlon said. "However, increasing the ESO grants in companies without such economic incentives for granting options does not lead to a correspondingly large increase in future earnings. In such cases, the ESO-related payoff is smaller."

For more information, contact:
Bernie DeGroat
Phone: 734.936.1015 or 734.647.1847