Asymmetric Benchmarking in Compensation: Executives are Paid for (Good) Luck But Not Punished for Bad

Principal-agent theory suggests that a manager should be paid relative to a benchmark that captures the effect of market or sector performance on the firm's own performance. Recently, it has been argued that we do not observe such indexation in the data because executives can set pay in their own interests, that is, they can enjoy "pay for luck" as well as "pay for performance". We first show that this argument is flawed. The positive expected return on stock markets reflects compensation for bearing systematic risk. If executives' pay is tied to market movements, they can only expect to receive the market-determined return for risk-bearing. We then reformulate the argument in a more appropriate fashion. If managers can truly influence the nature of their pay, they will seek to have their pay benchmarked only when it is in their interest, namely when the benchmark has fallen. Using a variety of market and industry benchmarks, we find that there is essentially no indexation when the benchmark return is up, but uncover substantial indexation when the benchmark has turned downwards. These empirical results are robust to a variety of alternative hypotheses and robustness checks, and suggest an increase in expected direct compensation of approximately $75,000 for the median executive in our sample, or about 5% of total compensation.

EVA versus Earnings: Does it Matter which is More Highly Correlated with Stock Returns?

Dissatisfaction with traditional accounting-based performance measures has spawned a number of alternatives, of which Economic Value Added (EVA) is clearly the most prominent. How can we tell which performance measures best capture managerial contributions to value? There is currently a heated debate among practitioners as to whether the new performance measures have a higher correlation with stock values and returns than do traditional accounting earnings. Academic researchers have instead relied on the variance of performance measures to gauge their relative accuracy. Our analysis pits EVA against earnings as two candidate performance measures. We use a relatively standard principal-agent model, but recognize that while the variability of each measure is observable, their exact information (signal) content is not. The model provides a formal method for ascertaining the relative value of such measures based on two distinct uses of the stock price. First, as is well-known, prices provide a noisy measure of managerial value-added. Our novel insight is that stock prices can also reveal the signal content of alternative accounting-based performance measures. We then show how to combine stock prices, earnings, and EVA to produce an optimally weighted compensation scheme. Surprisingly, we find that the simple correlation between EVA or earnings and stock returns is a reasonably reliable guide to their value as an incentive contracting tool. This is not because stock returns are themselves an ideal performance measure, rather it is because correlation places appropriate weights on both the signal and noise components of alternative measures. We then calibrate the theoretical improvement in incentive contracts from optimally using EVA in addition to accounting earnings at the firm and industry level. That is, we empirically estimate the "value-added" of EVA by firm and industry. These estimates are positive and significant in predicting which firms have actually adopted EVA as an internal performance measure.

Market-Indexed Executive Compensation: Strictly for the Young

Academics have long argued that incentive contracts for executives should be indexed to remove the influence of exogenous market factors. Little evidence has been found that firms engage in such practices, also termed "relative performance evaluation". We argue that firms may not gainmuch by removing market risks from executive compensation because (i) the market provides compensation for bearing systematic risk via the market risk premium and therefore the executive desires positive exposure to such risks, and (ii) the executive can, in principle, adjust her personal portfolio to o.set any unwanted market risk imposed by her compensation contract. A testable implication is that stock-based performance incentives will be weaker when idiosyncratic risks are large but that market risks will have little e.ect. The data tend to support this hypothesis. In the full sample of CEO compensation from ExecuComp, stock-based incentives are strictly decreasing in firm-specific risk. Market-specific risks, however, are insignificantly related to incentives. The story changes somewhat when we distinguish between younger and older CEOs. Our theory is arguably less applicable to younger CEOs who have more non-tradeable exposure to systematic risk through their human capital. Consistent with this argument, we find that market risks have a negative e.ect on stock-based incentive pay for younger CEOs, while they don’t for older CEOs. This in turn implies that the traditional argument for indexation is indeed valid for younger CEOs, and we find some evidence in favor of this proposition. Specifically, we find evidence of indexation for younger but not for older CEOs. Even for younger CEOs, however, the e.ect is far too weak to remove the e.ects of market risk. This is consistent with our finding that market risk reduces pay-performance for young CEOs, but leaves the question of why there is not more indexing for such executives.

Do Stock Prices Incorporate the Potential Dilution of Employee Stock Options?

Employee stock options represent a significant potential source of dilution for many shareholders. It is well known that reported earnings tend to understate the associated costs, but an efficient stock market will show no such bias. If by contrast stock prices underestimate the future costs implied by stock option grants, option exercises will produce negative abnormal returns. We design and implement a stock-picking rule based on predictions of stock-option exercise using widely available data. The rule identifies stocks that subsequently suffer significnt negative abnormal returns using either a CAPM or the three factor Fama-French benchmarks. According to our point estimates, if the cost of employee stock options as a fraction of market capitalization is 10%, the stock will subsequently exhibit a negative abnormal return of between 3% and 5%. There is some evidence of market learning in that the abnormal returns tend to fall over time. We use a restricted sample of actual stock exercises and find that the reduced power of our trading rule does not reflect a reduced ability to predict stock option exercise. It also does not seem to reflect improved accounting disclosure since the portion of option costs recognized in diluted earnings per share appears to be priced by the market in all our sample years.

Credit Ratings as Coordination Mechanisms

In this paper, we provide a novel rationale for credit ratings. The rationale that we propose is that credit ratings can serve as a coordinating mechanism in situations where multiple equilibria can obtain. We show that credit ratings provide a "focal point" for firms and their investors. We explore the vital, but previously overlooked implicit contractual relationship between a credit rating agency and a firm. Credit ratings can help fix the desired equilibrium and as such play an economically meaningful role. Our model provides several empirical predictions and insights regarding the expected price impact of ratings changes, the discreteness in funding cost changes, and the effect of the focus of organizations on the efficacy of credit ratings.http://deepblue.lib.umich.edu/bitstream/2027.42/39841/3/wp457.pd

Credit Ratings as Coordination Mechanisms

In this paper, we provide a novel rationale for credit ratings. The rationale that we propose is that credit ratings can serve as a coordinating mechanism in situations where multiple equilibria can obtain. We show that credit ratings provide a "focal point" for firms and their investors. We explore the vital, but previously overlooked implicit contractual relationship between a credit rating agency and a firm. Credit ratings can help fix the desired equilibrium and as such play an economically meaningful role. Our model provides several empirical predictions and insights regarding the expected price impact of ratings changes, the discreteness in funding cost changes, and the effect of the focus of organizations on the efficacy of credit ratings.coordination, credit ratings, multiple equilibria

Market-Indexed Executive Compensation: Strictly for the Young

Academics have long argued that incentive contracts for executives should be indexed to remove the influence of exogenous market factors. Little evidence has been found that firms engage in such practices, also termed 'relative performance evaluation'. We argue that firms may not gainmuch by removing market risks from executive compensation because (i) the market provides compensation for bearing systematic risk via the market risk premium and therefore the executive desires positive exposure to such risks, and (ii) the executive can, in principle, adjust her personal portfolio to o.set any unwanted market risk imposed by her compensation contract. A testable implication is that stock-based performance incentives will be weaker when idiosyncratic risks are large but that market risks will have little e.ect. The data tend to support this hypothesis. In the full sample of CEO compensation from ExecuComp, stock-based incentives are strictly decreasing in firm-specific risk. Market-specific risks, however, are insignificantly related to incentives. The story changes somewhat when we distinguish between younger and older CEOs. Our theory is arguably less applicable to younger CEOs who have more non-tradeable exposure to systematic risk through their human capital. Consistent with this argument, we find that market risks have a negative e.ect on stock-based incentive pay for younger CEOs, while they don't for older CEOs. This in turn implies that the traditional argument for indexation is indeed valid for younger CEOs, and we find some evidence in favor of this proposition. Specifically, we find evidence of indexation for younger but not for older CEOs. Even for younger CEOs, however, the e.ect is far too weak to remove the e.ects of market risk. This is consistent with our finding that market risk reduces pay-performance for young CEOs, but leaves the question of why there is not more indexing for such executives

Do Stock Prices Incorporate the Potential Dilution of Employee Stock Options?

Employee stock options represent a significant potential source of dilution for many shareholders. It is well known that reported earnings tend to understate the associated costs, but an efficient stock market will show no such bias. If by contrast stock prices underestimate the future costs implied by stock option grants, option exercises will produce negative abnormal returns. We design and implement a stock-picking rule based on predictions of stock-option exercise using widely available data. The rule identifies stocks that subsequently suffer significnt negative abnormal returns using either a CAPM or the three factor Fama-French benchmarks. According to our point estimates, if the cost of employee stock options as a fraction of market capitalization is 10%, the stock will subsequently exhibit a negative abnormal return of between 3% and 5%. There is some evidence of market learning in that the abnormal returns tend to fall over time. We use a restricted sample of actual stock exercises and find that the reduced power of our trading rule does not reflect a reduced ability to predict stock option exercise. It also does not seem to reflect improved accounting disclosure since the portion of option costs recognized in diluted earnings per share appears to be priced by the market in all our sample years

The Optimal and Actual Use of EVA versus Earnings in Actual Compensation

Proponents of EVA and related 'shareholder value' measures intend to replace earnings and to supplement stock returns by including their own measures in managerial compensation schemes. Stern Stewart's EVA appears to be the most widely recognized measure. However, there are not very many firms have explicitly adopted such schemes. One obvious reason, which we account for explicitly, is that they are not appropriate for all firms. An additional, less obvious fact, is that firms can directly or even indirectly mimic EVA measures. Firms such as Clorox and O.M. Scott use their own performance measures, which are arguably variants of EVA. In this paper, we use publicly available estimates of firm level EVA and examine whether firms pay according to it regardless of their explicit policies. This research approach captures the fact mentioned above, that firms can do home-made EVA performance evaluation. We adapt the technique of Garvey and Milbourn (2000) to model the optimal weight placed on EVA at the firm level. There is enormous cross-sectional heterogeneity in the estimated 'value-added' of EVA for various firms. With our estimates of optimal weights, we verify empirically that compensation paid to the top five executives in over 2,000 firms is highly consistent with our optimal compensation arrangements

Evolution of Organizational Scale and Scope

This paper examines the determinants of organizational scale and scope, with applications to various industries, including financial services. We build a model in which new opportunities arise for firms, but the skills needed to exploit them effectively are unknown. Early investments in these new opportunities expand scope and allow firms to learn the skills needed to make more efficient production decisions later on. The value of early scope expansion is thus increasing in the strategic uncertainty about the skills needed for future success in exploiting new opportunities. The disadvantage of early scope expansion is that it requires irreversible investments before actual demand is known. This demand uncertainty means potential losses since the investment cannot be recovered when demand does not materialize. Thus, early entry into a new activity involves a tradeoff, and this tradeoff works in favor of early entry under two conditions. First, there must be sufficiently high strategic uncertainty about the skills needed for success in the new activity. Second, the firm 's existing operations must be sufficiently profitable to give it the necessary deep pockets to absorb the potential loss of the capital invested early if there is no demand. This perspective allows us to link the optimality of scope expansion to the degrees of competition in the firm's existing activities as well as the new activity, and the development of the capital market. Moreover, to the extent that a scale-expanding merger deepens the firm's pockets, scale expansion will facilitate scope expansion and thus precede it