Thomas S. Zorn

The Association Between Executive Stock Option Plan Changes and Managerial Decision Making

This paper examines the behavior of managerial investment, dividend, and capital structure decisions subsequent to the adoption of stock options as part of the compensation package. Previous studies have documented a positive stock market reaction to changes in incentive compensation plans. The specific changes that such plans induce remain unclear. Surprisingly, firms that increase incentive stock option plans experience earnings declines, on average, relative to their industries. A decline in expenditures on R&D and an increase in selling, general and administrative expenses is also documented.

The Incentive Effects of Flat‐Fee and Percentage Commissions for Real Estate Brokers

This paper analyzes the incentive affects of flat-fee and percentage commission systems from the perspective of the economic theory of agency. Under a plausible set of assumptions the systems provide equivalent incentives. However, the relative desirability of the two systems depends upon the pricing strategy employed and factors specific to the individual. In general, neither system perfectly aligns the interests of the agent with those of the property-owner. A surprising result of the analysis is that the optimal listing price when an agent is employed may be below the first-best price. The first-best price, or residual maximizing solution to the principal-agent problem from the perspective of the property-owner, is the solution that would occur if the agents interests were perfectly aligned with those of the principal. This study suggests that the use of a percentage versus a flat-fee commission may be due to information costs rather than price discrimination on the part of brokers. Copyright American Real Estate and Urban Economics Association.

An empirical test of tournament theory: the Senior PGA Tour

Using data from the Senior PGA Tours we analyze the incentive effects of rank order tournaments. Previous studies using data from the PGA Tour reached conflicting conclusions. To resolve the issue, the Senior PGA Tour was chosen for its unique format where players are not cut from the tournament before completion, eliminating any survival bias. The findings support the hypothesis that the level of prizes in Senior PGA tournaments influences players’ performance, indicating that tournaments can be used to motivate performance.

Empirical Tests of the Fundamental-Value Hypothesis in Land Markets

The land-price boom of the 1970s followed by the bust of the 1980s generated considerable interest in the determination of land prices and the study of whether those prices reflect fundamental value. In this article, three techniques are used to examine the fundamental-value hypothesis in Iowa and Nebraska agricultural land markets. Duration dependence tests indicate that land markets are not affected by rational expectations bubbles. Conversely, Markov chain and time-reversibility tests suggest that land prices depart from fundamental value due to the existence of nonrandom price changes and asymmetric land price patterns. The results of this research should be viewed as a complement to the existing body of knowledge in our quest to enhance our understanding of agricultural land-price movements.

Allocating total wealth: a goal programming approach

Abstract Prior linear goal programming (LGP) models have demonstrated that multiple goals (e.g. liquidity, return on investment, etc.) can be considered in addition to the goal of maximizing wealth. Unfortunately, these prior studies have not considered a real-world investors total wealth including nonmarketable assets. In this paper an LGP model is developed for allocating an investors total wealth. Demonstration of the informational efficiency of the modeling approach in portfolio analysis is also presented.

Return Predictability and the P/E Ratio: Reading the Entrails

The P/E ratio has been used by practitioners and economists as an indicator of market valuations. Shiller [2000] warned that P/E ratios were dangerously high relative to their historical averages. This ratio, however, should in an efficient market vary with factors such as risk, time preferences, inflation, and market expectations. The authors use the residuals from a regression that controls for the effect of these factors on the E/P ratio to provide information about the behavior of the market. They find that the residuals from the model provide a reliable signal of future market behavior.

Risk taking in tournaments

Tournament theory provides important insights into organizational reward systems. It examines the incentive properties of reward systems based on rank‐order rather than absolute individual performance. Tournament theory may explain the pattern of managerial pay. It may also explain risk‐taking behavior by mutual fund managers. We use data from the PGA tour to examine the pattern of risk‐taking by professional golfers in an explicit tournament. The PGA tour provides a natural laboratory where such behavior can be studied. Our evidence shows that behavior by players in golf tournaments is consistent with the predictions of tournament theory.

Do residual earnings price ratios explain cross-sectional variations in stock returns?

Purpose - – Variations in price/earnings (P/E) ratios are explained in a rational expectations framework by a number of fundamental factors, such as differences in growth expectations and risk. The purpose of this paper is to use a regression model and data from four sample periods (1996, 2000, 2001, and 2008) to separate the earnings/price (E/P) ratio into two parts – the portion of E/P that is related to fundamental determinants and a residual portion that cannot be explained by fundamentals. The authors use the residual portion as an indicator of over or undervaluation; a large negative residual is consistent with overvaluation while a large positive residual implies undervaluation. The authors find that stocks with larger negative residuals are associated with lower subsequent returns and reward-to-risk ratio, while stocks with larger positive residuals are associated with higher subsequent returns and reward-to-risk ratio. This pattern persists for both one and two-year holding periods. Design/methodology/approach - – This study uses a regression methodology to decompose E/P into two parts – the portion of E/P than is related to fundamental determinants and a residual portion that cannot be explained by fundamentals. Focussing on the second portion allows us to isolate a potential indicator of stock over or undervaluation. Using a sample of stocks from four time periods (1996, 2000, 2001, and 2008, the authors calculate the residuals from a regression model of the fundamental determinants of cross-sectional variation in E/P. These residuals are then ranked and used to divide the stock sample into deciles, with the first decile containing the stocks with the highest negative residuals (indicating overvaluation) and the tenth decile containing stocks with the highest positive residuals (indicating undervaluation). Total returns for subsequent one and two-year holding periods are then calculated for each decile portfolio. Findings - – The authors find that high positive residual stocks substantially outperform high negative residual stocks. This is true even after risk adjustments to the portfolio returns. The residual E/P appears to accurately predict relative stock performance with a relatively high degree of accuracy. Research limitations/implications - – The findings of this paper provide some important implications for practitioners and investors, particularly for the stock selection, fund allocations, and portfolio strategies. Practitioners can still rely on a valuation measure such as E/P as a useful tool for making successful investment decisions and enhance portfolio performance. Investors can earn abnormal returns by allocating more weights on stocks with high E/P multiples. Portfolios of high E/P multiples or undervalued stocks are found to enjoy higher risk-adjusted returns after controlling for the fundamental factors. The most beneficial performance holding period return will be for a relatively short period of time ranging from one to two years. Relying on the E/P valuation ratios for a long-term investment may add little value. Practical implications - – Practitioners and academics have long relied on the P/E ratio as an indicator of relative overvaluation. An increase in the absolute value of P/E, however, does not always indicate overvaluation. Instead, a high P/E ratio can simply reflect changes in the fundamental factors that affect P/E. The authors find that stocks with larger negative residuals are associated with lower subsequent returns and coefficients of variation, while stocks with larger positive residuals are associated with higher subsequent returns and coefficients of variation. This pattern persists for both one and two-year holding periods. Originality/value - – The P/E ratio is widely used, particularly by practitioners, as a measure of relative stock valuation. The ratio has been used in both cross-sectional and time series comparisons as a metric for determining whether stocks are under or overvalued. An increase in the absolute value of P/E, however, does not always indicate overvaluation. Instead, a high P/E ratio can simply reflect changes in the fundamental factors that affect P/E. If interest rates are relatively low, for example, the time series P/E should be correspondingly higher. Similarly, if the risk of a stock is low, that stock’s P/E ratio should be higher than the P/E ratios of less risky stocks. The authors examine the cross-sectional behavior of the P/E (the authors actually use the E/P ratio for reasons explained below) after controlling for factors that are likely to fundamentally affect this ratio. These factors include the dividend payout ratio, risk measures, growth measures, and factors such as size and book to market that have been identified by Fama and French (1993) and others as important in explaining the cross-sectional variation in common stock returns. To control for changes in these primary determinants of E/P, the authors use a simple regression model. The residuals from this model represent the unexplained cross-sectional variation in E/P. The authors argue that this unexplained variation is a more reliable indicator than the raw E/P ratio of the relative under or overvaluation of stocks.

Mortgage Debt: The Good News

The usual advice given to the public by financial planners and the popular press is that less debt is better and in particular owning your own house outright is a desirable goal. We show that this advice is often wrong because mortgage debt acts as an inflation hedge. Mortgage debt also has a valuable refinancing option in case interest rates fall and an abandonment option if the value of the property declines. Mortgage debt is often seen simply as necessary because of peoples limited financial assets. Specifically, people can purchase a home only if they resort to borrowing. Employing a numerical model, we demonstrate that some level of mortgage debt is valuable to many individuals who do not face such a constraint. The model is able to simulate over a wide range of plausible assumptions the impact of mortgage debt on a households wealth. Home ownership provides households a hedge against rental increases, but exposes them to the vagaries of the local real estate market. Our model shows that mortgage debt allows individuals to hedge against inflation and local market risk. The model allows an analyst to vary assummptions to examine the impact of the mortgage decision on a particular household.