Accounting Earnings Versus Stock Prices

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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.