Managerial Ability and Value Relevance of Earnings

Abstract

We examine how management ability affects the extent to which capital markets rely on earnings to value equity. Using a measure of ability that captures a management team’s capacity of generating revenues with a given level of resources compared to other industry-peers, we find a strong positive association between managerial ability and the value relevance of earnings. Additional tests show that our results are robust to controlling for earnings attributes and investment efficiency. We use propensity score matching and 2-SLS instrumental variable approaches to deal with the issue of endogeneity. For further identification, we examine CEO turnover and find that newly hired CEOs with better managerial abilities than the replaced CEOs increase value relevance of earnings. We identify weak corporate governance and product market power as the two important channels through which superior management practices play important role in the corporate decision-making process that positively influence the value relevance of earnings. Overall, our findings suggest that better managers make accounting information significantly more relevant in the market valuation of equity.

Keywords: Managerial Ability, Value Relevance, Corporate Governance, Market Power

JEL Classification: M41, M12