Misvaluation, CEO Equity-Based Compensation, and Corporate Governance

Abstract

We investigate empirically whether misvaluation of the firm’s stock price affects CEO equity-based compensation, controlling for industry and year effects, economic determinants, board governance characteristics, and institutional ownership. Among firms that award stock options, we find that CEOs of overvalued firms receive higher stock option compensation, lower cash compensation and higher overall total compensation. The findings are robust using alternative regression methods, including rank variable regressions, Tobit analysis, and the Heckman 2SLS procedure to control for the endogenous decision of whether to award grants. We find that misvaluation does not influence the probability that grants are awarded. The results suggest that an overvalued firm awards higher grants to meet the manager’s reservation utility from another job, to maintain performance incentives, to acquiesce to greater rent extraction, and to reduce the likelihood of paying for luck. Furthermore, we find that the firm subsequently underperforms more when it awards higher option grants because the board is weak, the CEO is able to extract rents, and the firm is overvalued. However, the firm over-performs when it awards more option grants because the firm has high growth prospects or a high fraction of institutional shareholders.