Knowledge that Transforms

We conduct a field survey to investigate whether current mid-level and future entry-level managers (collectively managers) subjectively value stock options and restricted stock consistent with economic theory. We find that managers, on average, subjectively value stock options at greater than their Black-Scholes value and greater than fair-value equivalent restricted stock. This result contrasts with conventional economic wisdom that risk-averse employees discount the Black-Scholes value of an option. With respect to stock options, our results also reveal that managers, on average, have a lottery ticket mentality when subjectively valuing options, they value shorter vesting periods, and they value longer terms to maturity. With respect to stock options and restricted stock, we find that managers tend to extrapolate recently rising stock price trends to arrive at their subjective values. Overall, our results suggest that in some cases standard economic theory does not accurately reflect how managers appear to subjectively value stock options and restricted stock.

Bayesian theory predicts an increase in market participants' reliance on reported current earnings to revise their expectations of future earnings when the uncertainty in future earnings is higher. Prior studies focus on price reactions and find negative associations between measures of earnings uncertainty and investors' reliance on reported current earnings. This study examines analysts' forecast revisions (of future earnings) around the announcements of current period earnings and finds positive associations between measures of earnings uncertainty and analysts' reliance on reported current earnings. The findings suggest that uncertainty measures and discount rates are correlated, and cross-sectional differences in the discount rate taint the interpretation of price reactions as evidence of expectation revisions under uncertainty. This study sheds additional light on the complex relationships among earnings uncertainty measures, price reactions to earnings surprise, and cost of capital.