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Review of Accounting Studies

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01.09.2010

Are CEOs compensated for value destroying growth in earnings?

verfasst von: Sudhakar Balachandran, Partha Mohanram

Erschienen in: Review of Accounting Studies | Ausgabe 3/2010

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Abstract

Prior research shows that firms generating earnings growth by improving profitability create shareholder value, while firms generating earnings growth through investment destroy value. This paper examines whether compensation committees consider this while determining CEO compensation. We first confirm prior results that growth from increased profitability is perceived by markets to add value while growth from investment does not. While growth from increased profitability is positively associated with compensation, so is growth from investment. The presence of institutional ownership increases the weight on growth from increased profitability, but does not reduce the weight on growth from investment. Further, value-oriented institutional ownership increases the sensitivity of compensation growth to growth from increased profitability and reduces the sensitivity to growth from investment. Contrarily, growth-oriented institutional ownership increases the sensitivity of compensation growth to growth from investment. Our results highlight the importance of understanding the nature of earnings growth in determining executive compensation.

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As in prior research, we use raw returns instead of market adjusted returns for two reasons. First, the value of stock based compensation depends on actual returns. Second, it is unclear how many firms use relative performance evaluation for compensation. In addition, Baber et al. (1999) recommend adding the level of net income in addition to the change in net income to compensation regressions. When we add the level of net income to our regressions, the coefficient on net income is insignificant and all other inferences unaltered. We therefore decide to focus on the specification with returns and changes in net income alone.

The tax rate is the prevailing statutory tax rate for each year, set to zero if a firm has net operating loss carry-forwards (NOLs), consistent with Biddle et al. (1997).

We estimate WACC by (1) estimating a CAPM cost of equity using 60 past monthly returns, (2) inferring after-tax cost of debt from interest expense, total interest bearing debt, and the tax rate, and (3) using market value of equity and book value of total debt for their relative weights. We estimate betas using at least 24 months and up to 60 months of lagged returns. Betas below 0.4 are set to 0.4, while betas above 3 are set to 3. If a beta cannot be estimated, we use the contemporaneous median beta for firms with the same 2-digit SIC code.

We thank John McInnis of the University of Texas for providing us with the SAS code to implement the two-way clustering. The code can be obtained from https://webspace.utexas.edu/~johnmac.

Prior literature, unlike this paper, does find a positive association between investment and current returns. One potential reason for this difference is that our sample consists of larger firms that face more scrutiny, making it less likely that investors will reward value diminishing investments.

We cannot compare coefficients on ΔROIC_t and ΔIC_t−1 as the former is a ratio and the latter represents (deflated) dollars invested. This is unlike the RI based decomposition where we break ΔNI_t into distinct components that add up to the total.

As a sensitivity analysis, we repeat the above analysis with two alternative proxies for compensation growth-the growth in the bonus component of total earnings and the growth in the number of options granted. The results are broadly similar for both measures of compensation growth using both the RI based decomposition as well as the profitability decomposition. Compensation growth shows a much stronger correlation with growth from investment, especially for stock option grants. While this seems reasonable given that option grants are supposed to be forward looking long term incentives, it must be noted that they are correlated strongly with value diminishing growth.

The results using the ROIC framework are slightly different as the interaction of PERSIST with investment growth (ΔIC_t−1) is insignificant.

We also examine the impact of institutional ownership on the relationship between earnings growth and stock returns by interacting NI_t, ΔNI_t, and components of ΔNI_t with INSTPER. When we decompose ΔNI_t into its components, we find that the interactions of both ΔRI_t as well as ΔIC_t−1* WACC_t with INSTPER are significantly positive. The latter indicates that investments are less likely to be perceived as value destroying when made by firms with significant institutional ownership. This provides evidence that institutional ownership makes it less likely that the investments that firms make destroy value.

The mean values for GRO_INST and VAL_INST were 15 and 18.4% respectively. Their total represents almost 70% of total institutional ownership of 48.9%.

βs are estimated with respect to R_m − R_f, SMB and HML using at least 24 and up to 60 months of monthly data. We assume risk premiums of 6, 2, and 4% for R_m − R_f, SMB, and HML respectively. If cost of equity cannot be computed, it is set to the median for firms in the same industry based on 2-digit SIC code.

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Titel: Are CEOs compensated for value destroying growth in earnings?
verfasst von: Sudhakar Balachandran
Partha Mohanram
Publikationsdatum: 01.09.2010
Verlag: Springer US
Erschienen in: Review of Accounting Studies / Ausgabe 3/2010
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-010-9136-1

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