Review of Quantitative Finance and Accounting, 23: 329–352, 2004
2004 Kluwer Academic Publishers. Manufactured in The Netherlands.
Stock Option Measures and the Stock
Department of Accounting & Business Law, Louisiana State University in Shreveport
Department of Accounting, College of Business Administration, Kent State University, Kent, OH 44242, USA
Abstract. The major purposes of this study are two fold. First, we investigate whether or not the dilutive effect
from stock options on the denominator of earnings per share is associated with the incurrence of stock repurchases.
We use the FASB dilution and the economic dilution as the direct dilution measures and examine their relationship
with stock repurchase decision. Second, we explore which of the extant measures of stock options can better
explain the incurrence of stock repurchases. Six extant measures of stock options from previous studies are used:
(1) the FASB’s treasury-stock EPS dilution method, (2) the economic dilution measure based on Core, Guay and
Kothari (2002), (3) the number of employee stock option exercises, (4) the number of stock option grants, (5) the
number of total stock options outstanding, and (6) the number of exercisable stock options.
Using a pooled cross-sectional sample from 1996–2000, we ﬁnd a positive association between the likelihood of
stock repurchases and the FASB dilution as well as the economic dilution in EPS, respectively. Thereby providing
support for the undo-dilution hypothesis. The highest incremental explanatory power is found when we add the
number of stock options exercisable to the baseline model. However, further analysis does not support the option-
funding hypothesis suggested by Kahle (2002). We provide two explanations for why exercisable stock options
better explain the stock repurchase decision.
Keywords: stock repurchases, stock options, earnings dilution
JEL Classiﬁcation: G35, M41, M52
The use of employee stock options in the compensation package of ﬁrms has grown rapidly
in the past decade. For example, Core, Guay and Kothari (2002) indicate that the me-
dian number of shares reserved for stock options as a percentage of shares outstanding
for all ﬁrms on Compustat increased monotonically from 4.6 percent in 1985 to 8.9 per-
cent in 1995. This dramatic increase in the number of outstanding stock options is likely
to affect ﬁrm valuation. First, employee stock options when exercised dilute the claims
of existing shareholders by transferring claims to employees. For example, Bens, Nagar
and Wong (2002) predict and ﬁnd that the exercise of employee stock options impose a
real cost on the ﬁrm in terms of foregone investment opportunities. Aboody, Barth and
Kasznik (2004) predict and ﬁnd that stock-based compensation expense is negatively as-
sociated with stock price, consistent with investors viewing stock-based compensation as