Abstract
We develop an agency-based model that provides a direct theoretical connection between compensation-earnings sensitivities (CERCs) and value-earnings sensitivities (ERCs). The model predicts that CERCs are increasing in ERCs. This relation between valuation and stewardship derives from the fact that the capitalization rate of earnings into value also influences the marginal product of current period actions that impact current earnings. Our empirical tests of the model provide evidence of a positive link between CERCs and ERCs, persistence and other agency-based determinants of CERCs from our model. We also conduct an empirical investigation of the existence of secular trends over the 1971-1995 time period in CERCs and in the importance of earnings relative to other information in explaining CEO cash compensation. In contrast to recent studies documenting declining trends in ERCs, we find no general time trend in CERCs. We find, however, a decline in the importance of earnings in explaining cash compensation relative to information reflected in stock returns.
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