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

3.3.3 Stock price levels and idiosyncratic volatility
Target Size Management has implications for the relationship between per share stock price levels and return
volatility. One result documented in Brandt et al. (2010) is that lower priced stocks have higher return
volatility. An interpretation of this relationship is that low priced stocks have higher volatility because they
have a low price, and that this is a result of a retail trader clientele effect. TSM suggest that causality may
run in the opposite direction. Firms with high earnings volatility may choose low prices as a result of EPS
incentives. To the extent that earnings volatility and return volatility are correlated, we would expect to see
similar empirical outcomes but with causality running in the opposite direction.
In unreported tests, we observe a nearly identical relationship between per share price levels and return
volatility (Brandt et al. (2010)) and per share price level and net income volatility (TSM). Distinguishing
between these two possible explanations is beyond the scope of this paper.
However, this highlights an
example of potential implications of target size management that are beyond financial reporting and EPS
outcomes.
4 Conclusion
A range of net income numbers will generate the same EPS number. This is because earnings per share
are rounded to the nearest penny. So, for any given EPS forecast, there is a range of total earnings that
will meet that forecast. We refer to the magnitude of this range as the size of the earnings target. The
size of the earnings target is a function of the number of shares outstanding. We find evidence consistent
with the view that managers engage in target size management - adjusting the firm’s quantity of tradeable
securities to affect the size of the range of net income numbers that meet EPS forecasts. We find that an
exogenous decrease in the probability of meeting earnings estimates causes managers to split their stocks,
thereby increasing the earnings target size. We find that this effect is stronger among firms whose managers’
compensation is highly sensitive to EPS surprises, and weaker among firms for which an increase in shares
would be highly costly (e.g., highly illiquid firms).
Target size management has real effects. We find that firms are more likely to meet EPS expectations
following an increase in shares. Simultaneously, these firms use less accounting and real earnings management
tools. Both of these associations are consistent with an increase in shares increasing the earnings target size.
Our results suggest that the magnitude of the firm’s long run usage of earnings management tools is a
managerial choice. This has implications for research examining the determinants of traditional earnings
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