The Market Response to Dilution Effects of Potential Common Stock

Listed companies are required to present earnings per share (EPS) and diluted earnings per share (DEPS) on the face of income statements as the sole financial ratio. DEPS measures a firm’s EPS as if potential common stock, such as stock options, convertible securities, and bonds with warrants, would be converted maximally into common stock. That DEPS does not equal BEPS indicates that the firm has potential common stock, which will generate dilution effects on EPS in the future. Consequently, DEPS conveys incremental information beyond earnings per share (EPS) regarding the dilution effects of potential common stock. The purpose of this paper is to examine whether the dilution effects disclosed in DEPS are reflected in the stock market, by analyzing the effects of dilution on price-earnings and return-earnings relations, using a sample of Korean listed companies for the period 1999-2007. 논문접수: 2009. 4. 1차수정: 2009. 5. 게재확정: 2009. 7. * I appreciate two anonymous referees for their valuable comments. 이 논문은 2009년도 서울시립대학교 연구년교수 연구지원에 의하여 연구되었음. ** Associate Professor, Department of Business Administration, University of Seoul, 서울시립대학교 경영학부 부교수(E-mail: jcpark@uos.ac.kr) Empirical evidence documents that firms with greater dilution effects have lower price-earnings and return-earnings coefficients. This result is also robust to the inclusion of control variables used in the previous research. Consequently, this paper provides evidence that investors in the stock market incorporate the dilution ffects of potential common stock into their share prices, regarding prospective dilution effects as costly.