Agency theory suggests that the compensation of chief executive officers (CEOs) should be linked to firm performance to motivate CEOs to maximize shareholder value. Further, the hypothesis of relative performance evaluation (RPE) states that the firm performance measure used in CEO pay should exclude the component driven by exogenous shocks. Despite much research in this area, the lack of consistent empirical evidence supporting the use of RPE in CEO compensation is an important unresolved puzzle. In my forthcoming Journal of Accounting and Economics paper Peer Firms in Relative Performance Evaluation, I study how the choice of peer group affects tests of RPE, which is a joint test of how incentives are granted and of what constitutes a peer group. Previous tests potentially lack power to detect evidence that supports RPE because peer groups chosen by researchers are incorrect. The challenge in choosing a RPE peer group is to identify the set of firms that are exposed to common shocks and share a common ability to respond to those shocks.
Ideally, a peer group should include firms that are similar along several characteristics (e.g., industry, size, diversification, and financial constraints). Yet considering all such characteristics simultaneously is not practical because it could result in peer groups composed of too few firms, which would be too noisy to filter external shocks. In this paper, I show that industry and firm size capture many of these characteristics. Specifically, when peer groups consist of firms within the same industry and size quartile, my empirical results show systematic evidence supporting RPE usage in CEO pay. The analysis includes both the level and the growth of total compensation flow regressed on firm stock performance, peer stock performance, and control variables.
To compare with previous studies, I test whether RPE is used when measuring peer performance with two common peer group definitions, namely, the S&P 500 index and firms within the same industry. I fail to find consistent evidence of RPE usage with either peer definition. I also find no evidence that accounting returns substitute for RPE in stock returns, or evidence of RPE in accounting returns when using industry-size peers. Last, I test for the presence of RPE when peer groups are formed based on industry plus other firm characteristics, such as diversification, financing constraints, and operating leverage. The evidence is inconsistent with RPE when using such peer groups. Evidence exists to support RPE usage in the level and growth of CEO pay when peers are defined as firms in the same industry and growth options quartile. However, when both industry size and industry-growth options peer performance are included, the results show that only industry-size peer performance is filtered from CEO pay.
The full paper is available for download here.