Product Market Peers and Relative Performance Evaluation
62 Pages Posted: 19 Jul 2015 Last revised: 17 May 2018
Date Written: May 15, 2018
We investigate the role of Relative Performance Evaluation (RPE) theory in CEO pay and turnover. RPE predicts that firms will filter out common shocks (i.e., those affecting the firm and its peers) while evaluating CEO performance and that the extent of filtering increases with the number of firms in the peer group. Despite the intuitive appeal of the theory, previous tests of RPE find weak and inconsistent evidence. To examine this hypothesis, we exploit recent advances in textual analysis and define peers based on firms’ product descriptions in their 10-K filings (Hoberg and Phillips, 2016). This alternative classification not only captures common shocks to firms’ product markets more effectively but also tracks the evolving nature of these markets as 10-Ks are updated annually. Using product market peers, we find three pieces of evidence consistent with RPE in relation to CEO pay – (i) firms on average filter out common shocks to stock returns, (ii) the extent of filtering increases with the number of peers, and (iii) firms completely filter out common shocks in the presence of a large number of peers. We also find consistent evidence for forced CEO turnover.
Keywords: Product market peers, Relative Performance Evaluation, CEO compensation, and Forced CEO Turnovers
JEL Classification: M40; M41; G30; J33
Suggested Citation: Suggested Citation