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Executives Overvalue their Stock Options, Study Suggests

February 1, 2007

For more information, contact: Benjamin Haimowitz,

How much are stock options worth to executives? That largely depends on whether they are in their pockets, according to a new study that probes how managers think about options.

Possession begets what behavioral researchers call an "endowment effect," which leads executives to overvalue their options, the report in the Academy of Management Journal suggests. As a result, companies could find it easier than they think to reduce the number of options they award.

The study also suggests that, thanks to the endowment effect, options commonly fail to achieve what is widely viewed as their main purpose -- namely, to spur executives to take managerial risks so as to increase their firms' growth and profits. The endowment effect helps explain, too, why backdating of options became as irresistible for companies as it apparently did.

Building on other scholars' behavioral research on decision-making, the study's authors -- Cynthia E. Devers of the University of Wisconsin, Robert M. Wiseman of Michigan State University, and R. Michael Holmes Jr. of Texas A&M University -- explore executives' thought processes with respect to options. They find that executives assign a worth to options in their possession that markedly exceeds their Black-Scholes value, the amount commonly included in company proxy statements as an estimate of what outside investors would pay for the options on an open exchange.

Yet, when managers are asked how much they would pay out of their pocket for identical stock options, the amount tends to be significantly lower than the Black-Scholes value.

This disparity between what managers are willing to accept (WTA) for stock options and what they are willing to pay (WTP) is characteristic of the endowment effect, the tendency of people to assign increased value to an asset once they gain ownership of it. As the authors put it, "The positive divergence of WTA values from WTP values demonstrates that, once awarded, managers attached a positive value to options in-hand, even though these options were unexercisable."

The new finding, like earlier research that Devers and Wiseman have presented at Academy of Management meetings, calls into question whether stock options encourage managerial risk-taking as much as they have widely been thought to do. The traditional reasoning, they write, has been that "stock options exhibit asymmetric [financial] risk, offering the opportunity for upside potential (via stock-price increases), without concurrent downside threats to current wealth."

But this view assumes "that holders do not recognize the potential value of unexercisable stock options as part of personal wealth." What the study's findings suggest instead is that "managers immediately endow value from unexercisable stock options into their perceptions of personal wealth. In other words, once awarded, holders count on receiving value from stock options and perceive this value as real wealth."

Thus, rather than being the managerial risk-takers they are supposed to be, executives whose options are in the money (that is, have an exercise price below the current price of the underlying stock) are likely to be cautious, reflecting another finding of behavioral research -- namely, that when an individual's assets are at stake, "minimizing losses is more important than maximizing gains."

With views about stock options misguided on so fundamental a point, it is no wonder, the authors conclude, that "despite years of research involving numerous studies, the influence of stock option compensation on managerial behavior remains unclear."

At the same time, they believe that the new findings provide insight into one type of activity that has only recently come to light -- namely, the backdating of executive stock options.

Says Wiseman: "A puzzle about backdating is why companies need to resort to it at all: if the idea is to enhance an options grant, why not just dole out more options instead of resorting to the backdating subterfuge? But, if executives are as inclined as our findings suggest to equate their stock options with wealth (even though it may be years before they can be cashed in), then options that are already in the money when granted are likely to have considerably more psychological impact than those which are merely at the money."

Wiseman adds: "Our findings recall the old adage, 'A bird in the hand is worth two in the bush.' The oddity here, though, is that the bird may not be hatching for a few years."

The study's findings derive from an experiment involving 94 executives enrolled in an MBA program. Virtually all were full-time managers in for-profit businesses; 86% had received stock options or some other form of contingent-based pay; and the average size of the budgets they administered in their jobs was $19.4 million.

The subjects were divided into two groups, each of which was presented with a slightly different fictional scenario. The subjects in one group were informed that, as executives of a large corporation with six publicly traded businesses, they were individually entitled to 100 stock options (exercisable in two years) in each of those enterprises. In order to limit the dilution effect of stock-based compensation, however, executives were being given a one-time opportunity to accept a cash payment in lieu of this stock-options award. Subjects were asked to indicate the amount of cash bonus they would require in order to convert the options to cash.

The scenario for the second group was similar, except in this case the managers had earned a cash bonus that the board wanted them to convert to stock options in each of the six publicly traded subsidiaries. Subjects had $10,000 per business to convert to stock options, and were asked to indicate the number of options per business they required.

All participants were presented with the same graphic representations of the six subsidiaries' performance during the prior year. In two cases, shares had risen from about $47 to about $53; in two cases, they had fallen from about $53 to $47; and in two cases they had begun and ended at about $50. In each of these pairs, one stock was highly volatile, fluctuating by about 45% of its value, while the other fluctuated by only 5% of its value.

The Black-Scholes values for stock options ranged from $16.46 (where the stock declined steadily over the prior year) to $34.39 (where the stock rose with high volatility), and averaged $25.84. The valuations of the WTA group (the one asked to set a cash price for their stock options) ranged from $28.41 (for a downward-trending stock with low volatility) to $46.17 (for an upward-trending stock with low volatility), and averaged $36.38. The valuations of the WTP group (the one asked to buy stock options with their bonuses) ranged from $16.02 (for a declining stock with low volatility) to 27.30 (for a rising stock with low volatility), and averaged $22.75.

The average value assigned by the WTA group to stock options was, therefore, about 40% higher than the average Black-Scholes value and about 60% higher than the average value assigned by the WTP group. In other words, executives estimated options in their pockets to be worth 60% more than options they would have to pay for.

Comments Wiseman: "Economists tend to believe that executives undervalue stock options -- that is, value them at less than Black-Scholes or other supposedly objective measures. This assumes completely rational executives, who reason that as holders of company-issued options they have less flexibility and bear more risk than investors who buy options on an open exchange. But the real-life executives in our experiment assigned their options a worth that exceeded Black-Scholes, not just when the underlying stock had risen in the previous year but even when it had declined. And the reason they did so, we believe, is the phenomenon that behavioral researchers have identified as the endowment effect, the tendency of people to assign increased value to an asset once they gain ownership of that asset."

Wiseman sees an important practical implication of the study -- namely, that corporate compensation designers may find it easier than they think to award fewer stock options to executives than they now do. "If managers overvalue their options as much as our findings suggest," he says, "companies ought to take advantage of it, particularly now that federal regulations mandate expensing of employee stock options and awarding them has a more immediate and measurable effect on profits than it formerly had."

The study, entitled "The Effects of Endowment and Loss Aversion in Managerial Stock Option Valuation," is in the February/March issue of the Academy of Management Journal. This peer-reviewed publication, now in its 50th year, is published every other month by the academy, which, with more than 16,000 members in 92 countries, is the largest organization in the world devoted to management research and teaching. The academy's other publications are the Academy of Management Review, Academy of Management Perspectives, and Academy of Management Learning and Education.

Media Coverage:
The Wall Street Journal. The Backdating Molehill. (Wednesday, March 07, 2007).
United Press International. Study Views Stock Options in the Hand. (Monday, February 12, 2007).

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