Firm-Specific Determinants of CEO Compensation

Section I: Introduction

Background

Chief Executive Officers (CEOs) are the operational and strategic leaders of the companies that they head. As the key figure and head of the business that they lead, a CEO’s compensation may affect various aspects of the business. First, a CEO’s compensation is a motivating tool for their performance (Sheikh, Shah, & Akbar, 2017). Therefore, the benefits offered to a CEO may motivate them to improve business performance or demotivate them. Besides, some aspects of CEO compensation may be attributed to the performance of the company.

Various factors have a significant influence on CEO compensation. One of the factors that have direct control over the compensation of company CEOs is the performance of the company that they lead. In most companies, CEOs have a variable aspect of their remuneration that is based on the company’s performance based on audited or unaudited financial statements for the firm (Angelis & Grinstein, 2015). Regarding company performance, CEO compensation is pegged on various factors.

The most common factor that CEO compensation is based on is the company’s profits. Company profits are the returns to its shareholders, investors, or proprietors. In order to improve company performance, CEOs are often remunerated based on the profits that they produce for the company in order to motivate them and encourage higher profitability (Fallatah & Fahd, 2015). Most companies have been basing part or all of their CEO compensation on the reported profits for their respective companies.

Another benchmark for CEO compensation that is closely related to profits is the sales for the company. Company sales drive and influence the profits reported for the company. When sales are high, profits are likely to increase. The sales of a company are a good measure of the level of activity and operational performance of the company. Thus, a CEO is compensated for improved sales performance (Elsayed & Elbardan, 2018).

In addition to company profits and sales, the profit margin is often another basis for measuring the effectiveness of the company and CEO remuneration. Profit margin is the balanced measure of the proportion of profits to the sales for the company. Using profit margins as a basis of CEO compensation is a measure of how effective a company manages its sales and expenses (Clifford & Lindsey, 2016). Thus, the use of profit margins as a basis for CEO compensation, rewards both revenue and expenditure effectiveness.

One of the objectives of investors is to maximize returns and grow their wealth. Wealth creation and growth in corporate and company investment is achieved through the increase in the value of shareholders’ equity and value for the business. As a way of encouraging CEOs to achieve more growth in equity, CEOs’ compensation is often based on the market value of the firm that they head (Cai, Cremers, & Wei, 2015). When the market value of the company increases, the shareholders’ investment increases, and so does the CEO’s compensation. On the other hand, when the market value of the company declines, the shareholders’ investment shrinks as well as the CEO’s compensation. Therefore, the CEO is motivated to improve the market value of the company to increase his or her compensation. Further, larger companies are more likely to pay higher to their CEOs than smaller companies (Smirnova & Zavertiaeva, 2017).

There are other factors determining CEO compensation that are not dependent on the performance of the firm. The experience of the CEO, just as other employees, contributes to the starting salary in the company. A more experienced CEO is more likely to negotiate higher starting remuneration than less experienced ones (Hamori & Koyuncu, 2018). Thus, the number of years as a CEO before the current company may be a key determinant of the CEO’s compensation.

CEO salaries and remuneration are usually subject to progressive growth in income. Therefore, the CEO benefits from periodic salary increments. When the CEO stays in the company for long, the salary increases over time (Hamori & Koyuncu, 2018). Thus, the CEO’s compensation increases with the length of stay in the current company. Therefore, a CEO’s length of tenure in the current firm usually influences their total compensation.

CEO compensation is rarely based on their age. However, the Age of the CEO usually has a positive correlation to their compensation. Although companies do not discriminately base their compensation on the age of the CEO, their experience and length of stay at the company may be dependent on their age. Thus, a CEO’s age may significantly determine their compensation based on confounding variables and attributes rather than as a result of direct causation.

The study will investigate the factors that determine the CEO’s compensation. Specifically, the study will determine the significance of performance-based factors on CEO’s compensation. A quantitative research approach will be used to evaluate and analyze various factors and their impact on CEO compensation. The study will evaluate and analyze the following research question; What is the impact of age, experience, company sales, profits, profit margin, the market value of the company, and tenure on CEO’s compensation?

The first section of the paper provides an introduction and background into the study as well as the reasons for conducting the research. Section two of the study represents the literature review of relevant research and academic materials related to the topic of study. The third section of the study represents the methods used in the study, including data collection methods and sources and analysis techniques to be used in the study. The fourth section represents the statistical analysis of the collected data as well as the discussion and interpretation of the results. The last section is the conclusion part that includes a summary of the study findings and their significance to the field of the study.

Section II: The Conceptual Framework

Section III: The Data and Methodology

Data

Secondary data is used in the study. The data for the study is collected from Bloomberg Businessweek by Wooldridge. It represents information about 277 US corporations on their CEO compensation and other attributes. Eight quantitative variables represent the dataset for the study. Salary is the dependent variable for the study measured on the ratio scale. It represents the annual compensation of the CEOs in thousands of dollars. Comten is a quantitative variable measured on the ratio scale representing the number of years that the CEO has worked in the company. Ceoten is a quantitative variable measured on the ration scale and representing the prior number of years as a company CEO. Sales is another variable measured on the ratio scale and represents the firm’s sales in millions of dollars.

Profit is a quantitative variable that is measured on the ratio scale and represents the amount of profits reported by the firm in millions. Age is also a quantitative variable measured on the ratio scale that represents the age of the CEO in years. Mktval is measured on the ratio scale and represents the end of year market value of the firm in millions of dollars. Finally, the profmarg is a quantitative variable that represents the profit margin of the company. The profit margin is reported as the percentage proportion of the profits to the sales of the company.

Analysis Plan

Both quantitative and inferential statistics will be used to analyze the data for the study. Measures of central tendency and distribution will be used to describe the data. Table 1 below shows the descriptive statistics for the study variables.

Table 1: Descriptive Statistics

The average annual salary for the sampled CEOs is $859,863, with a standard deviation of $541,817. The minimum CEO salary is $84,000 while the maximum is $5,299 million. There is a wide variation in CEO compensation, as shown by the difference between the minimum and maximum salaries. The average age for the CEOs is 56.46 years, with a standard deviation of 8.32 years. The youngest CEO is 33 years old, while the eldest CEO is 86 years old.

The relationship between the independent variables and the dependent variables is evaluated. A correlation analysis is conducted to determine the relationship between the study variables. Table 2 below shows the results of the correlation analysis.

Table 2: Correlation analysis results

There is a weak positive correlation between CEO salary with sales (r = 0.302), profits (r = 0.312) and market value (r = 0.311). There is a weak negative correlation between CEO salary and the number of years in the company (r = -0.218). This relationship is against the expected relationship. A longer stay in the company would be expected to be associated with a higher CEO salary. Age, prior number of years as company CEO, and the company’s profit margin have very weak correlations to the CEO salary.

An analysis of the correlations between the independent variables shows a strong to medium correlation between the following pairs of variables sales and profits, sales and market values, and profits and market value.

References

Angelis, D. D., & Grinstein, Y. (2015). Performance Terms in CEO Compensation Contracts. Review of Finance, 19(2) 619–651 https://doi.org/10.1093/rof/rfu014.

Cai, J., Cremers, M., & Wei, K. D. (2015). CEO Compensation and Stock Mispricing: How Do Boards React to Mutual Fund Flow-Driven Price Pressure? SSRN, http://dx.doi.org/10.2139.

Clifford, C. P., & Lindsey, L. (2016). Blockholder Heterogeneity, CEO Compensation, and Firm Performance. Cambridge University Press, 51(5) 1491-1520.

Elsayed, N., & Elbardan, H. (2018). Investigating the associations between executive compensation and firm performance: Agency theory or tournament theory. Journal of Applied Accounting Research.

Fallatah, Y. A., & Fahd, K. (2015). CEO Compensation, Firm Performance and Corporate Governance: An Empirical Investigation of Saudi Arabian Companies.

Hamori, M., & Koyuncu, B. (2018). Experience Matters? The Impact of Prior CEO Experience on Firm Performance. Wiley Online Library, 54(1) https://doi.org/10.1002/hrm.21617.

Sheikh, M. F., Shah, S. Z., & Akbar, S. (2017). Firm performance, corporate governance and executive compensation in Pakistan. Applied Econometrics, 50(18) 2012-2027 https://doi.org/10.1080/00036846.2017.1386277.

Smirnova, A. S., & Zavertiaeva, M. A. (2017). Which came first, CEO compensation or firm performance? The causality dilemma in European companies. Research in International Business and Finance, 42 658-673.