Read an excellent article on "The Relationship between Employee Stock Options and Stock Repurchases".Perhaps the time is ripe for this issue of corporate governance to take a fronseat and the regulator to see that companies are not misusing this option.
The following excerpt from the article is given below;
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 go up.
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 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.
In addition, 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 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 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."
Research by Daniel A. Bens and M. H. Franco Wong