ATJ Asian Tax Journal

Asian Tax Journal

Print ISSN 1738-3323 Online ISSN 2733-9270

The Conversion Possibility of Potential Common Stocks and the Explanatory Power of Diluted EPS for Stock Price

  • Lee, Se－Young The Catholic University of Korea

Asian Tax Journal Vol. 12 No. 4 (2011), pp. 517-541

Abstract

The economic implication of potential common stocks’ dilution effects has been examined by a few researchers. These studies can be separated into two categories. Firstly, MarquardtㆍWiedman(2005) and MarquardtㆍWiedman(2007) investigated whether managers’ decisions are affected by the dilution effect, and secondly, HusonㆍScottㆍWier (2001), CoreㆍGuayㆍKothari(2002), Park (2009) and Lee(2011) investigated how market responds to the dilution effects. However, the problem in the prior research is that they are implicitly based on the premise that all of the current potential common stocks would be converted into common stocks, regardless of their possibility that they would be really converted. However, the dilution effect of potential common stocks can have the economic implications only when we are sure that the potential common stocks will be really converted into common stocks in the future. Therefore, prior studies should be expanded by considering, in the analysis, the conversion possibility of potential common stocks. In the perspective of the above, this paper is to examine how the informativeness of diluted EPS varies with the conversion possibility of potential common stocks, compared to the informativeness of EPS. To complete the purpose of this paper, 516 firm -years were selected from the firms listed on the Korean Securities Market, from 2001 to 2008. The sample firms’ accounting period ends in year end, and the firms with no information of DEPS were deleted from the sample. The results are as follows. The coefficient of DEPS for firms with high conversion possibility of potential common stocks is smaller by 2.582 than the coefficient of DEPS for firms with low conversion possibility, when price-earning model is used. This result has not been changed; 1) when the financial variables are scaled with other scalers, 2) when the conversion possibility is measured using the change in earnings, not the change in stock prices, 3) when the last operating day’s stock price of March in year t+1 is used as a dependent variable, instead of the last operating day’s stock price of December in year t, 4) when the effect of loss is controlled for, and 5) other factors, such as firm size, growth rate, and risk, are controlled for. The results shown in the above mean that the dilution effect have different economic implication with the conversion possibility of potential common stocks.

Keywords

  • potential common stocks
  • dilution effect
  • diluted EPS
  • EPS
  • explanatory power for stock price
  • value relevance
  • conversion possibility

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