Alternative explanations for the association between market values and stock-based compensation expenditure

We argue that stock-based compensation can be used either as a reward for past performance or as an incentive for future performance. We predict that there is a negative relation to market values when stock-based compensation is granted primarily as a reward to chief executives for past performance, while there is a positive relation when stock-based compensation is used to provide incentives for enhanced future performance. This prediction is tested on a sample of 259 firm-year observations for the period 1999-2004 using an instrumental variables approach, where the sample is classified into the 'reward' and 'incentive' groups on the basis of prior period performance and option characteristics. Our findings are that there is a positive association between stock-based compensation expenditure and market values for the 'incentive' group, but we find overall an insignificant relation for the 'reward' group. A number of sensitivity tests confirm the main findings.