97. CEO Stock Options and Analysts’ Forecast Accuracy and Bias

In this study, we investigate the relations between CEO stock options and analysts’ earnings forecast accuracy and bias. We argue that a higher level of stock options may induce managers to undertake riskier projects, to change and/or reallocate their effort, and to possibly engage in gaming (such as opportunistic earnings and disclosure management) and hypothesize that these managerial behaviors will result in an increase in the complexity of forecasting and, hence, in less accurate analysts’ forecasts. We also posit that analysts’ optimistic forecast bias will increase as the level of stock options pay increases. We reason that as forecast complexity increases with stock options pay, analysts, needing greater access to management’s information to produce accurate forecasts, have incentives to increase the optimistic bias in their forecasts. Alternatively, a higher level of stock options pay may lead to improved disclosure because it better aligns managers’ and shareholders’ interests. The improved disclosure, in turn, may result in more accurate and less biased analysts’ forecasts.

Using ordinary least squares estimation, we test these hypotheses relating the level of CEO stock options pay to analysts’ forecast accuracy and bias on a sample of firms from the Standard & Poor’s ExecuComp database over the period 1993–2003. Our OLS models relate forecast accuracy and forecast bias (the dependent variables) to CEO stock options (the independent variable) and controls for earnings characteristics, firm characteristics, and forecast characteristics. We measure forecast accuracy as negative one times the absolute value of the difference between forecasted and actual earnings scaled by beginning of period stock price and forecast bias as forecasted minus actual earnings scaled by beginning of period stock price. We control for differences in earnings characteristics by including earnings volatility, whether the firm has a loss, and earnings surprise; for differences in firm characteristics by including firm size, growth (measured as book-to-market ratio, percentage change in total assets, and percentage change in annual sales), and corporate governance quality (measured as percentage of shares outstanding owned by the CEO, whether the CEO is also chairman of the board of directors, number of annual board meetings, and whether directors are awarded stock options); and for differences in forecast characteristics by including analyst following and analyst forecast dispersion. In addition, the models include controls for industry and year. We use four measures of options: new options, existing exercisable options, existing unexercisable options, and total options (sum of the previous three), all scaled by total number of shares outstanding, and estimate two models for each dependent variable, one including total options and the other including new options, existing exercisable options, and existing unexercisable options. We also use both contemporaneous as well as lagged values of options in our main tests.

Our results indicate that analysts’ earnings forecast accuracy decreases and forecast optimism increases as the level of stock options (particularly new options and existing exercisable options) in CEO pay increases. These findings suggest that the incentive alignment effects of stock options are more than offset by the investment, effort allocation, and gaming incentives induced by stock options grants to CEOs. Given that analysts’ forecasts are an important source of information to capital markets, our finding of a decline in the quality of the information provided by analysts has implications for the level and variability of stock prices. It also has implications for information asymmetry and cost of capital, as well as for valuation models that rely on analysts’ earnings forecasts.