Does CEO Ability Matter for Shareholders?
51 Pages Posted: 17 Mar 2009
Date Written: March 16, 2009
I develop a model in which CEO ability affects profits, and agents learn gradually about a CEO's ability. Following good news about the CEO's ability, the level of CEO pay rises, which may offset some or all of the benefits to shareholders from the good news. I estimate the model's parameters using GMM and data on stock returns and changes in CEO pay. Estimates indicate CEO ability matters greatly for shareholders: there is a huge amount of uncertainty about a new CEO's ability, and shareholders (as opposed to the CEO) capture 96% of the surplus resulting from a change in the CEO's perceived ability. In terms of both direction and magnitude, the model helps explain the sensitivity of CEO pay to both contemporaneous and lagged stock returns, as well as the relation between CEO tenure and stock return volatility. The model makes sharp predictions about abnormal stock returns around unexpected CEO deaths, but these predictions have limited support in the data.
Keywords: CEO, ability, compensation, learning
JEL Classification: G34, J31
Suggested Citation: Suggested Citation