Are CEOs Compensated for Value Destroying Growth in Earnings?

Abstract

Prior research has shown that firms who generate earnings growth by improving profitability create value for shareholders, while firms who generate earnings growth through investment destroy value. This paper examines whether compensation committees take this into account while determining CEO compensation. We first confirm the results from prior research that internally generated growth is perceived by markets to add value while investment-driven growth does not. We find that while internally generated growth is positively associated with compensation, so is investment-driven growth. There is evidence to suggest that the weight placed on investment-driven growth in earnings is higher despite such earnings growth not delivering value to shareholders. We find partial support for the hypothesis that institutional investors act as monitors to ensure that managers are compensated efficiently. The presence of institutional ownership increases the weight on internally generated growth, but does not reduce the weight on investment-driven growth. We further show that value oriented institutional ownership increases the sensitivity of compensation growth to internally generated earnings growth and reduces the sensitivity to investment-driven earnings growth. Contrary to this, growth oriented institutional ownership increases the sensitivity of compensation growth to investment-driven earnings growth. Our results indicate the importance of understanding the different sources of earnings growth in the determination of executive compensation.