Tests for Relative Performance Evaluation Based on Assumptions Derived from Proxy Statement Disclosures
Posted: 11 Aug 2010
Date Written: June 30, 2010
The main purpose of this paper is to explore the empirical evidence supporting the use of relative performance evaluation (RPE) in executive compensation which is mixed. This is puzzling since studies of firm disclosures indicate that firms claim to use RPE based on both accounting measures and stock returns. Those few studies that do find empirical support observe it either with an accounting performance measure or stock returns, but not both. The lack of strong consistent empirical support for RPE is due, in part, to the fact that the preponderance of tests for RPE incorporate unsubstantiated assumptions about the way firms apply RPE. This includes the compensation measure to which RPE is applied and the way in which firms use firm-own and peer group performance when determining compensation.
In this study, our empirical tests for RPE are based on assumptions derived from an examination of firms’ disclosures about their RPE use. Our test results provide support for the use of RPE among 1998 S&P 500 firms with both stock returns and return on equity. To our knowledge, this is the first study to find support for RPE with both stock returns and an accounting performance measure. Through a series of sensitivity analyses, we also provide insight into the amount of detail researchers need to build into their empirical tests in order to find support for RPE.
Keywords: Relative Performance Evaluation, Agency Theory, Compensation Committee Report.
JEL Classification: J33, M41, M52
Suggested Citation: Suggested Citation