Hidden Gems: Do market participants respond to performance expectations revealed in compensation disclosures?

Abstract

We find that a new compensation disclosure item on expected payouts from performance-based stock grants reveals unique information regarding future firm performance. Extracting inferred performance expectations from the disclosures, we find that firms disclosing the highest expected grant payout significantly outperform in ROA, Q, sales growth, and profit margin over the next two years, while those disclosing the lowest expected payout underperform. The embedded information is not captured by other information channels, such as managerial earnings guidance, 10-K sentiment, insider selling activities, unexplained CEO pay, and analyst forecasts. Investors and analysts do not fully incorporate the information and are later surprised around earnings announcement days. A portfolio that buys firms with the highest performance expectation and shorts firms with the lowest expectation earns significantly positive abnormal returns. Our findings suggest that the enhanced compensation disclosure contains valuable information, but investors underreact to information that is difficult to collect and process.