I would like to thank Ramji Balakrishnan (the editor), two anonymous reviewers, and Dan Weiss

(the discussant) for constructive suggestions. The study has benefited from comments from Mary

Ellen Carter, Scott Duellman, Ann Gabriel, Alan Jiang, Siyi Li, Richard Lu, Vivek Mande, Michal

Matejka, Kevin Murphy, Myungsoo Son, Toby Stock, Wim Van der Stede, I-Ling Wang, Martin

Wu, Steve Wu, seminar participants at Auburn University, California State University at

Examining Shareholder Value Creation over CEO Tenure: A New Approach

to Testing Effectiveness of Executive Compensation

Abstract

This paper examines the relationship between CEO compensation and shareholder

value added over CEO tenure. The research design exploits two fundamental attributes of

CEO compensation and shareholder value added: (i) both CEO compensation and shareholder

value added aggregate naturally over CEO tenure, and (ii) extending the time interval over

which the two variables are measured is likely to result in a better match between CEO

compensation and shareholder value created by the CEO. I measure CEO compensation with

I. INTRODUCTION

For more than two decades, academics, policymakers, and the media have debated over

the high levels of executive compensation, questioning whether they are consistent with

shareholder interests (e.g. Jensen and Murphy 1990; Hall and Liebman 1998; Bebchuk and Fried

2004). Prior studies have not reported consistent results about performance outcome of

executive compensation but instead have raised concerns regarding the ability of executive

compensation to adequately align the interests of top executives and shareholders (for reviews,

see Murphy 1999; Core et al. 2003; Jensen et al. 2004; Devers et al. 2007). During the current

financial crisis, we have witnessed an unprecedented level of interest in executive compensation.

Politicians and the media have argued that current executive compensation practices motivate

executives to maximize short-term profits at the expense of long-term benefit. Consequently, the

federal government and Congress are implementing more regulations to constrain executive

compensation (Bebchuk 2009; Muprhy 2010). However, if we do not have a definitive answer

to the question of whether executive compensation has the desired effect on shareholders’ wealth,

then any regulation constraining executive compensation will distort and weaken executives’

incentives to deliver long-term results. Carefully designed research will inform and guide

policymakers in drafting any potential regulation on executive compensation. In this paper, I

examine the relationship between CEO compensation and shareholder value added over CEO

tenure.

No prior studies have examined the association between CEO compensation and

shareholder value added over CEO tenure. There are four advantages of conducting executive

compensation research over the long time frame of CEO tenure. First, by using CEO tenure as

the window for observing CEO compensation and performance, we mitigate the horizon problem

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in executive compensation research. Managers usually have shorter time horizons than

shareholders (Narayanan 1985), and therefore, the bonus plan in executive compensation

contracts motivates them to behave myopically and sacrifice shareholder value (Dechow and

Sloan 1994). For example, Graham et al. (2005) report that a majority of managers would forgo

a project with positive net present value (NPV) if the project would cause them to fall short of

the current quarter consensus forecast. The labor market for executives also encourages them to

invest in projects with quick payback. Managers perceived as having higher ability receive

higher compensation (Murphy and Zabojnik 2007). Thus, managers prefer to invest in short-term

projects that produce higher short-term returns in order to generate a perception of greater

ability. By acting myopically at the beginning of their tenure, managers can obtain high

compensation at the current company as well as earn a good reputation that will increase their

market value. In the long-run, however, stock price will drop due to sacrificed long-run profit for

short-run profit, and CEO wealth will be negatively affected when the CEO holds a large number

of stocks or stock options. It is therefore important to examine CEO pay and shareholder value

over the long-run. Devers et al. (2007) acknowledge this problem with the conclusion that “time

may exhibit a confounding influence on research findings” (p. 1041).

The second advantage of examining CEO pay and shareholder value over the long-run is

the mitigation of the ex post settling-up problem. The ex post settling-up problem arises when

managers are compensated for expected future cash flows that do not result in materialization in

the future (Leone et al. 2006). For example, if the CEO receives a bonus for signing a value

increasing long-term contract but the contract is later canceled, stockholders cannot recoup the

bonus paid for the unrealized cash flows. However, the CEO’s wealth in the form of equity

holding will shrink after the contract is cancelled. A much less severe ex post settling-up problem

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for the shareholders occurs when CEOs are paid in equity compensation forms (Leone et al.

2006). Because the long time horizon allows us to examine cash compensation, equity

compensation, and shareholder value, we get a complete picture of CEO pay and shareholder

value creation.

The third advantage of the long time horizon is that it reduces measurement errors in both

the CEO compensation and shareholder value variables. Take stock options as an example.

Realized gains from exercising stock options in a particular year are usually from a CEO’s stock

options accumulated over time, sometimes over the CEO’s tenure. If we count the gains as a

single year’s compensation, it distorts the relation between CEO compensation and shareholder

value. Instead, if we aggregate all realized gains over a CEO’s tenure and compare the gains

with performance during the same period, we present a fair picture of the pay-performance link.

This is consistent with the notion that aggregate measures can be preferred to individual (annual)

measures because they serve as an avenue for measurement errors to cancel (Arya et al. 2004).

Furthermore, short-term stock return can be high or low due to a variety of factors such as

business cycle, discount rates, and investor sentiment. However, over the long-term, these factors

tend to even out. Easton et al. (1992) show that aggregation over multiple years effectively

reduces measurement errors for such variables as earnings and stock returns.

Finally, aggregation of CEO compensation and shareholder value added over CEO tenure

creates a one-to-one correspondence between CEO compensation and CEO performance. Prior

studies examining the association of this year’s CEO compensation with future years’ stock

returns fail to consider the factor that this year’s CEO may not be the CEO of future years when

we examine performance consequences. Given that the annual CEO turnover rate is about 15%