Why might a CEO and other top executives want to manipulate the short term stock price? Two aspects of executive compensation create an incentive to manipulate prices. First, top executives have performance reviews that depend on financial performance. EPS, ROIC or ROE are example measures of financial performance. Because a large part of a manager's compensation is the bonus, managers have a strong incentive to delay expenses and move forward revenues in order to satisfy the performance review and earn the larger bonus. Tying manager compensation to stock price makes sense because shareholders are the owners and elect the Board which chooses the executives. The second aspect of compensation is that bonuses to top executives often include shares and options. On the one hand, shares and options align an executive's interests with that of the shareholders. On the other hand, a manager has an incentive to boost stock prices prior to selling shares or exercising call options to increase gains.
How can a CEO alter the performance measures? Imagine a CEO delays writing down an asset to meet analyst EPS expectations. Asset write downs hit the current periods income statement as an expense under GAAP. By delaying the asset write down, the CEO boosts the current period's GAAP EPS and shifts the write down expense to a future period, perhaps expensing the write down in a period when the opportunity for a large bonus is remote.
The phrase "in the short term" is in the title of the post because in the long term information is revealed. The CEO will disclose the write down in a future period. In the short term, the CEO would only bother to manipulate financial measures if the stock price reacts. Because there have been legal actions against executives demonstrating intent to manipulate the stock price, there is some evidence that executives believe they can manipulate markets.
Does shifting the write down expense move stock prices in the short term? Assume there is a probability that a manager is manipulating earnings in the current period and that all investors agree on the probability. Remember we do not know for sure if the manager is manipulating earnings until a future period when for example the write down occurs. Investors will bid up the stock price when seeing a higher than expected EPS figure, but investors will not bid up the price by as much as they would if they knew with certainty that the executive was not manipulating earnings.
But wait! Is not the risk that a manager is manipulating earnings diversifiable? To be diversifiable, we would be assuming a manager's choice of whether or not to manipulate earnings is independent of that of other managers i.e. not correlated with the market portfolio. If the risk is diversifiable, then diversified investors would not require a risk premium for this idiosyncratic risk (see my past post on idiosyncratic risk).
Does this mean that diversified investors will give the stock price full credit for the higher EPS even if there exists a probability the manager manipulated the EPS? No. The flaw in the reasoning of the last question is that if the stock price gave full credit to the EPS, the expected returns on the portfolio would be lower than the required return of a diversified investor. The chance that managers manipulated the EPS means there is a chance of a negative future shock to returns. If this negative shock is predictable because investors know the probability the manager manipulated the EPS, then the expected returns would be lower. Thus, the price has to react to the higher EPS but not fully even if the risk is diversifiable. The price reaches a point that conditional on all information - including information about that one firm - the expected returns only depend on covariance with the stock market.
Important: There is no risk premium for the idiosyncratic probability the manager manipulated earnings even though the price does not fully react to the EPS. The price does not fully react because there is a probability that the EPS is manipulated. The price simply reacts to the expectation of a risk neutral investor of EPS, which will be less than the reported EPS if there is a probability of manipulation.
The market's estimate of the managers probability to manipulate is uncertain. Over a long time horizon, the market learns with more precision the manager's probability. Therefore, manager's can trick the market by manipulating with a higher probability in the short term. Of course, the market will learn that the manager manipulates earnings and adjust the probability of future manipulation upwards. The manager then will have a harder time manipulating the market.
Manipulating the market requires uncertainty - i.e. the market cannot know perfectly when the manager is manipulating earnings. There also has to be information asymmetry. As we saw in the example, if the market believes the manager has a probability of manipulating earnings, then the stock price moves less than if the EPS were not manipulated. The manager can manipulate by manipulating with a different probability than the market judged. This misjudgment requires information asymmetry. For example, the market may have believed that Enron's managers had only a low probability of manipulating earnings. The highly manipulating managers had a large incentive to manipulate because the market seriously misjudged the probability of manipulation. However, the gap between true and market-perceived probability requires information asymmetry - i.e. the market is tricked. Enron's management was skilled at hiding the shenanigans from the market.
A manager does not have an incentive to manipulate stock prices by making poor investment decisions. So long as the manager communicates the investment to the market, the stock price will react more to a higher NPV project always. Stories that managers boost short term stock prices with buybacks is not plausible because the manager would have preferred to invest in any other higher NPV project and communicate the project to the market. Managers have no incentive to hide higher NPV projects from the market.
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