Morrison 1
Matt Morrison
Dr. Mike Nelson
Econometrics Project
3/28/11
Statement of the Problem
According to a survey by the Hay Group, bonuses for top executives grew by 30
percent between 2009 and 2010. In fact, between 1980 and 2003, the average firm
market value of the largest 500 firms increased in real terms by 500%. Prior research
suggests that due to the increase in “productivity” by 500%, constant returns to scale
should prompt one to believe that CEO compensation would as well increase by 500%.
A substantial increase in firm size has also led to growing compensation packages. The
marginal impact of a CEO’s talent is assumed to increase with the value of the firm under
his control (Gabaix, Landier, 2007). This provokes the question of whether or not an
increase in gross profit from a base year (2008), market capitalization, Gross Domestic
Product (measuring aggregate growth or decline), Consumer Price Index, market value,
number of employees, and dividend yield will result in a similar increase to a CEO’s total
compensation. The main economic theory I will use to explain the differences in CEO
compensation between firms relates to wage determination in competitive markets. More
precisely how differences in labour productivity and revenue creation relate to wage
determination. Workers who are the most productive, efficient, and generate the highest
revenue for their firm should be paid the highest. By comparing the total compensation
packages of CEO’s across different firms we will be able to test this theory. The model I
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have derived includes both internal and external factors that may be correlated to the
determination of compensation in a given year
Literature Review
Determinants of CEO Pay: A Comparison of ExecuComp and Non-ExecuComp
Firms
Much research has been done on the determinants of CEO compensation, including
different models containing different parameters. ExecuComp is a data set collected by
Standard and Poors on compensation of American corporate executives, including stock
and options ownership. “We document that firms included in the ExecuComp database
tend to be larger, more complex, followed by more analysts, have greater stock liquidity
levels, and have higher total, but less concentrated, institutional ownership than other
firms” (Cadman, Klasa, Matsunaga, 2010). Research completed using the database finds
support for three key predictions. One, ExecuComp firms rely more heavily on earnings
and stock returns in determining CEO cash compensation. Two, the weight on earnings
is more sensitive to differences in the extent of growth opportunities for ExecuComp
firms. Three, the positive relationship between institutional ownership concentration and
the value of the stock option grants is strong for ExecuComp firms (Cadman, Klasa,
Matsunaga, 2010).
Although their research points towards differences in CEO
compensation structure between ExecuComp and Non-Execucomp firms, we will only
focus on that of the ExecuComp firms due to the fact that they comprise approximately
88 percent of the market capitalization of publicly traded firms in the U.S. A model was
formed to test whether firms placed greater weights on aggregate financial measures.
The model used the annual change in the natural logarithm of the CEO’s total cash
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compensation or total compensation from the panel data derived from ExecuComp and
Non-Execucomp firms as its dependent variable. Independent variables included the
annual change in income before extraordinary items deflated by average stockholders
equity (Δcomp), annualized stock return assuming dividend reinvestment (annualized
stock return), and whether or not the firm was in the ExecuComp database (1) or
otherwise (0). The study finds that cash compensation is more sensitive to stock market
returns for S&P 500 firms than non-S&P 500 firms. Also, there was not significant
evidence that there was a difference in the weight placed on earnings and stock returns
between these two classifications of firms. Finally, the higher the complexity of the firm,
the stronger analyst following, and higher stock liquidity leads to the altering of the
contracting environment.
Why has CEO pay increased so much?
Xavier Gabaix and Augustin Landier developed a simple equilibrium model of CEO pay
in their paper. The paper established an equilibrium model in which CEO’s with a
median talent would be matched with a firm that is of median size. As a result CEO’s
with the most talent will manage the largest firms, as this will maximize their impact and
economic efficiency. The model also predicts that, as CEO’s compensation will increase
with both the size of his firm and the size of the average firm in the aggregate. The
following model estimates the wage of a CEO in the median of firm sizes:
w (n) = D (n∗ ) S(n∗ )^β/α S (n) ^ γ−β/α
Gabaiz and Landier suggested that a firm’s total market value (debt plus equity), earnings
before interest and taxes (EBIT) and revenue were possible proxy’s to judge firm size.
However, after further review total market value was the only proxy that had a significant
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positive coefficient in the regression equation. It was also the variable with the highest
predictive power in the model. Although they concluded that the significant rise in CEO
pay since the 1970’s was due to large increases in aggregate firm size, they also
concluded that the rest of the rise could be explained by overpayment by a small number
of firms.
Model
Exec = β0 + β1GDP - β2INF + β3GP + β4EMP + β5MV + βDY + ε
GDP- positive coefficient, as Gross Domestic Product rises a companies salary
budget also rises along with higher currency values due to aggregate growth.
INF- negative coefficient, inflation is a general rise is the price of goods and services,
which can lead to lower compensation as a result of a company attempting to lower
overhead costs to production of their goods and services.
GP- positive coefficient, increases in gross profit means the productivity of a CEO
has increased. As we have already established the most productive CEO should
obtain the highest compensation package.
EMP- positive coefficient, the larger the size of the company in terms of number of
employees, the higher revenue generally is.
MV- positive coefficient, the higher the market value or market capitalization of a
company, the higher the perceived value of the CEO and ability to compensate one
substantially.
DY- positive coefficient, a larger dividend yield usually means that a company has
experienced good profits and as a result is rewarding its stockholders for their
support. As a result if the company is doing well the CEO will be compensated
accordingly.
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Source Table
Variable
Exec
Definition
Executive name
Source
hosted.ap.org/specials/interactives/
_business/executive_compensation/
index.html
CO
Company employing
executive
hosted.ap.org/specials/interactives/
_business/executive_compensation/
index.html
TC2008
Total compensation
(base salary,
incentives, stock
option and restricted
stock, other
compensation) 2008
Total compensation
(base salary,
incentives, stock
option and restricted
stock, other
compensation) 2009
Gross Domestic
Product 2008 - the
total market values of
goods and services
produced by workers
and capital within a
nation's borders
during a given period
hosted.ap.org/specials/interactives/
_business/executive_compensation/
index.html
Gross Domestic
Product 2009 - the
total market values of
goods and services
produced by workers
and capital within a
nation's borders
during a given period
Consumer Price Index
2008 - an index of the
cost of all goods and
services to a typical
www.bea.gov/national/nipaweb
/tableview.asp?selectedtable=6&
viewseries=no&java=no&request3
place=n&3place=n&fromview=yes&
freq=year&firstyear=2008&lastyear
=2010&3place=n&update=update&
javabox=no#mid
TC2009
GDP2008
GDP2009
INF2008
hosted.ap.org/specials/interactives/
_business/executive_compensation/
index.html
www.bea.gov/national/nipaweb
/tableview.asp?selectedtable=6&
viewseries=no&java=no&request3
place=n&3place=n&fromview=yes&
freq=year&firstyear=2008&lastyear
=2010&3place=n&update=update&
javabox=no#mid
www.bls.gov/cpi/cpid09av.pdf
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consumer
INF2009
GP2008
GP2009
EMP
MV
DY
Consumer Price Index
2009 - an index of the
cost of all goods and
services to a typical
consumer
Gross Profit of
company employing
executive in 2008
Gross Profit of
company employing
executive in 2009
Number of employed
persons by company
Market Value or
Market Capitalizationcalculated by
multiplying a
company's
shares outstanding
by the current market
price of one share.
Used to judge firm
size.
www.bls.gov/cpi/cpid09av.pdf
www.yahoo.finance.com
www.yahoo.finance.com
www.yahoo.finance.com
media.ft.com/cms045f63ee-4c
50-11de-a6c5-00144feabdc0.pdf
Dividend Yield- a
media.ft.com/cms045f63ee-4c
financial ratio
50-11de-a6c5-00144feabdc0.pdf
that shows how much
a company pays out in
dividends each year
relative to its share
price