Executive Compensation Negatively Related To Stock Returns

The Relation Between Executive Compensation and Stock Price Performance

Michael J. Cooper

University of Utah – David Eccles School of Business

Huseyin Gulen

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Purdue University – Krannert School of Management

P. Raghavendra Rau

University of Cambridge; UC Berkeley – Haas School of Business

January 30, 2013


We find evidence that CEO pay is negatively related to future stock returns for periods up to three years after sorting on pay. For example, firms that pay their CEOs in the top ten percent of excess pay earn negative abnormal returns over the next three years of approximately -8%. The effect is stronger for CEOs who receive higher incentive pay relative to their peers. Our results appear to be driven by high-pay induced CEO overconfidence that leads to shareholder wealth losses from activities such as overinvestment and value-destroying mergers and acquisitions.

Over the past two decades, the academic literature on agency theory and executive compensation has argued that CEO compensation should be aligned to firm performance (see for example, Holmström, 1979, Grossman and Hart, 1983, and Jensen and Murphy, 1990). Over the last few years, politicians and the media have increasingly argued that CEOs are paid too much and that current executive compensation practices push employees to take short-term risks with little regard for the long-term effect on their companies. Consequently, recent regulatory proposals have argued for more pay being offered through restricted stock or other forms of long-term compensation designed not to reward short-term performance.1 To the extent that long-term compensation plans offer incentives to CEOs to act in the best interest of shareholders going forward, and to the extent that markets do not fully incorporate pay information when it is made public, this would seem to imply a positive relation between incentive pay and future returns.

However, the empirical literature does not document a consistently positive link between pay and future returns. While early work (see for example, Abowd, 1990, Lewellen, Loderer, Martin, and Blum, 1992, and Masson, 1971) finds a positive relation between pay and future stock returns, recent papers document a negative relation between executive pay and future returns.

For example, Core, Holthausen, and Larcker (1999) find that the predicted component of compensation arising from board and ownership structure has a negative relation with subsequent firm operating and stock return performance and conclude that firms with greater agency problems perform worse. Malmendier and Tate (2009) show that “superstar” CEOs subsequently underperform for up to two years after they win important business awards. An issue with all these papers is that they analyze compensation either over short time periods or in relatively small specialized subsets of firms. However, recent theoretical models, such as Benmelech, Kandel, and Veronesi (2010), suggest that there exists a link between incentive compensation and future stock returns in a potentially broader set of firms (i.e., all firms employing stock-based compensation).

In this paper, we present new evidence on the relationship between CEO pay, CEO overconfidence, and future stock returns using a much broader data set than previous studies. We show that highly paid CEOs exhibit firm investment and personal portfolio choice behavior that is consistent with being overconfident and that firms with the highest paid and most overconfident CEOs earn lower future returns relative to other CEOs.

Specifically, we analyze the relation between CEO compensation and future returns using the entire Execucomp universe (largely the S&P1500 firms) over the 1994-2011 period, a much longer period than previous studies. We sort firms annually into industry and size benchmark adjusted CEO compensation (we deem this “excess” pay) deciles. We find a strong negative relation between annual excess pay and future abnormal returns. In the year after the firms are classified into the lowest and highest excess compensation deciles respectively, firms in the lowest total excess compensation decile earn insignificant abnormal returns.