Do Stock Prices Incorporate the Potential Dilution of Employee Stock Options?

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Abstract
Employee stock options represent a significant potential source of dilution for shareholders in many firms. It is well known that reported earnings systematically understate the associated costs, but an efficient stock market will show no such bias. If by contrast stock prices fail to fully incorporate the future costs implied by stock option grants, option exercises will produce negative abnormal returns. We design and implement a stock-picking strategy based on predictions of stock-option exercise using publicly-available information. We are able to identify stocks that subsequently exhibit significant negative abnormal returns using either a CAPM or three-factor Fama-French benchmark. We also find weak evidence that the returns are more negative for firms whose earnings shocks are more persistent, as predicted in a recent theoretical model in which limited investor attention is the source of mispricing. More consistent with the notion of limited investor attention, we find our results to be stronger in months where firms issue quarterly reports which alert investors to any dilution stemming from the exercise of employee stock options.