Alternative explanations for the association between market values and stock-based compensation expenditure

Hong Kong Polytechnic University, School of Accounting and Finance
Publication Type:
Journal Article
Journal of Contemporary Accounting and Economics, 2009, 5 (2), pp. 95 - 107
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The relation between stock-based compensation and market values has been tested previously in the literature, but the empirical findings are inconsistent; as both negative and positive relations have been documented. The objective of this study is to provide an explanation for why both negative and positive relations between stock-based compensation expenditure and market values can be consistent with rational markets. We argue that stock-based compensation can be used either as a reward for past performance or as an incentive for future performance. We predict that there is a negative relation to market values when stock-based compensation is granted primarily as a reward to chief executives for past performance, while there is a positive relation when stock-based compensation is used to provide incentives for enhanced future performance. This prediction is tested on a sample of 259 firm-year observations for the period 1999-2004 using an instrumental variables approach, where the sample is classified into the 'reward' and 'incentive' groups on the basis of prior period performance and option characteristics. The key findings confirm the proposition. In particular, there is a significant negative association between stock-based compensation expenditure and market values for the 'reward group'. A number of sensitivity tests confirm the main findings.
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