Gaming the Float: How Managers Respond to EPS-based Incentives

2.2 Time series determinants of shares outstanding
In this section, we examine the conditions under which managers might choose to change shares outstanding.
In the previous section, we discuss how the level of shares should be related to earnings volatility and the
concavity of payoffs. If one of these cross sectional determinants were to change, then we would expect the
manager to correspondingly change shares outstanding and, in fact, we use a shock to net income volatility
(relative to forecasts) to address causality. However, we expect that much of the within-firm variation in
shares is driven not by changes in compensation contracts or analyst coverage, but simply by firm growth.
Dechow and You (2012) make the observation that the precision of an EPS number is increasing in the
level of EPS. We offer one way to quantify this effect; - the firm needs to produce net income within ± 0.5
E[|EP S|]
% of expected net income to meet expectations. Therefore as the firm’s net income grows, the target size as
a fraction of the firm’s expected net income shrinks. 12
It is well known that managers increase shares following earnings growth (see e.g.
Lakonishok and
Lev (1987) and Asquith et al. (1989)). We examine a conditional hypothesis that is unique to target size
management. This helps distinguish TSM from other explanations that also predict an increase in shares
following earnings growth.
The relationship between earnings growth and target size is non-monotonic, with a kink at EPS=0.
Earnings growth shrinks the target size, but only for firms with positive earnings. If the firm has negative
earnings and experiences earnings growth (a positive change in earnings), then this growth actually widens
the range making it easier to meet expectations, not harder. Therefore, we expect increases in shares to
follow earnings growth, but only among positive EPS firms.
H5: Managers increase shares following earnings growth, but only for firms with positive earnings.
A manager can compensate for a shrinking target by using more accruals, guidance, and other earnings
management tools. However, usage of these earnings management tools is costly. As the costs of the usage
of these alternatives increase, the manager can choose to “reset” the size of the earnings target, restoring
it to a size appropriate for the now-larger firm. Therefore, we expect that the manager will either meet
12 To be clear, if the firm’s mean earnings grows but there is no growth in variance, then this growth has no effect on the
probability of meeting forecasts, despite the fact that the target size relative to firm size has shrunk. Therefore, thinking of
target size relative to firm size is useful only if the size of the firm in terms of expected net income is related to the volatility
of the firm’s net income. Not surprisingly, we find empirically that earnings growth is associated with higher levels of earnings
volatility going forward.
11