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Accounting Earnings Versus Stock Prices
Accounting Earnings versus Stock Prices
•Top management’s incentive compensation is usually linked to stock prices and accounting earnings.
•Why not link it to stock prices alone?
Stock prices are affected by economic factors that are outside of a manager’s control (e.g., macroeconomic, political factors).
Consequently, stock prices may be a poor indicator of managerial performance.
Combining both mitigates this problem
•A second reason for using accounting earnings
•Expected versus delivered performance
Firm X hires manager Y on December 31, 1997.
Stock price of X jumps by 10%! Why?
Market’s expectationsregarding the company’s future performance improve.
Accounting earnings of 1998 increases by 10%!
oWhy?
oManager Y’s actions produce an actualimprovement in the financial performance of X in 1998. Stock prices anticipated this improvement in 1997 at the time of the earnings announcement.
•By combining stock prices and earnings to reward managers, a firm can reward a manager for his/her strategic planning and operational execution.
•Of course, stock prices do reflect the delivered performance of the manager as well.
But if payment is on the basis of expected performance, then what do you do if the manager shirks subsequently? (Moral hazard problem)
Earnings provide a straightforward measure of deliveredperformance.
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