orgtheory.net

executive compensation and shareholders

Brayden

Tyler Cowen has an interesting NY Times column dealing with executive compensation. He details the findings of a new paper by Xavier Gabaix and Augustin Landier addressing the relationship between CEO compensation and the market capitalization of the firm. Essentially, they show that the two grow in tandem. Executive compensation has increased six-fold over the last twenty years, and the average market value of firms has increased by the same proportion. Cross-segment differences in executive compensation can also be explained by segment-level value increases.

So is this a refutation of the overpaid executive thesis? Not exactly. Their findings also indicate that among the top 250 firms, differences in financial performance cannot explain variation in executive compensation, and it is among these firms that you see the highest level of compensation.

The two also find that the best chief executives do not seem to have much more talent than other chief executives in what they define as the top 250. By their calculations, replacing the No. 250 chief executive with the No. 1 will increase the value of the company by only 0.014 percent. The No. 1 chief executive receives much more compensation, but that is mostly because he manages a larger company and thus his talent has a longer reach.

Essentially, larger companies have more money to spend on CEO hires, so they end up rewarding them disproportionately to their contribution to the firm's performance. If I understand the finding correctly, the top firms in a particular industry are the most likely to egregiously overpay their CEOs.

Why even be concerned about what the top firms do anyway? If they have the extra cash, let them waste it as they please. One reason to be concerned is that inflated compensation may spread throughout the industry. As competition intensifies (following the logic of the paper), even the lower-valued firms in the segment will begin offering irrational compensation. Competition, the driving dynamic of compensation according to Gabaix and Landier, may force boards to sacrifice shareholders' interests (maintaining the long-term value of the company) in order to stay afloat by recruiting executives they perceive as having the best talent in their industry.

The other reason to be concerned with bloated compensation, even among the richest firms, is simply that it is bad for shareholders. In a recent study published in the Journal of Corporate Finance, Kenneth Martin and Randall Thomas find that shareholders get antsy when executives are compensated with stock options that dilute stock value by spreading profit over a larger number of shares. When executive compensation plans dilute the stock, shareholders tend to bid down the price of the stock even further. If more executives are getting paid through stock option plans, which they are, overompensation may lead to decreased market value, and ultimately, less cash flow.

Written by brayden king

May 18, 2006 at 3:53 pm

5 Responses

Subscribe to comments with RSS.

  1. I was struck by the amount of hand-waving involved in Gabaix and Landier’s leap from their theoretical corporation size distribution to market cap.

    While I’m not keen on how they set up their model — if the CEO labor market is neoclassical and frictionless, then it isn’t cold in Wisconsin in the winter — I have two main concerns.

    One is that you can look at other size indicators, and you’re potentially back to the overpaid-CEO problem. Real NIPA corporate profits aren’t up sixfold (it’s more like threefold since 1980), and much of the recent increase has as much to do with public policy as CEO talent. Likewise, why should CEOs ride the equity premium puzzle, unless you want to argue that CEOs drive the willingness of the public to hold equities.

    The other is that their model seems to suggest that any employees whose talent (or effort) causally relate to profits should be riding the CEO pay trajectory — obviously from different levels — to a much greater extent than they seemingly are. The Marginal Revolution comments contain some efforts to explain how lower-tier employees don’t contribute to profits. I’m disinclined to buy as I see that as inappropriately attributing all of the ‘value creation’ to the final decision-maker, when decisions in many coporations actually integrate effort and talent throughout the ranks.

    Like

    Tom Bozzo

    May 18, 2006 at 5:27 pm

  2. Tom – I agree that the problem begs the question of where value emerges in the first place. Interestingly, I don’t see many of the org. learning or knowledge scholars arguing that CEOs generate much of the net value of the firm. Most argue that value is embedded in institutionalized routines and practices, while others argue that individual employees are the carriers of value. Teppo probably has something to say about that.

    But is the CEO the primary source of value creation in a firm? I doubt it. Following Russ Coff, I think you can make the argument that CEOs are just better positioned to appropriate rents than anyone else in the corporation. Thus, when the firm does well, the CEO gets compensated better than all of the other stakeholders.

    Like

    brayden

    May 18, 2006 at 5:34 pm

  3. To make sense of my last comment – you should probably read this post.

    https://orgtheory.wordpress.com/2006/04/28/what-makes-a-classic/

    Like

    brayden

    May 18, 2006 at 5:44 pm

  4. Undoubtedly there are market imperfections in the way CEO/Executive Compensation packages are set. Any time you don’t have a homogenous good and imperfect information, you are likely to encounter problems. (I’d be hard pressed to make the case the CEOs are fungible or that we can gleen highly reliable insight into their likely performance in a new organization.) At the same time, the debate on Executive Compensation all-too-often focuses on the Crystal Ratio — which outside of employee engagement misses the point — or shareholder fairness. The latter argument often implicitly assumes that shareholder contributions to the wealth creation process are somehow more sacrosanct than those of the executive team. We’ve been exploring this issue along with several others at: http://cfo.exbdblog.com/.

    Like

    Scott Bohannon

    May 9, 2007 at 8:59 pm

  5. […] *Just noted that this is old news, Brayden posted on it nearly two years ago. […]

    Like


Comments are closed.

%d bloggers like this: