Growth options and relative performance evaluation

• DOI: https://doi.org/10.1108/IJAIM-10-2014-0067
• Date: 07 March 2016
• Pages: 38-55
• Published date: 07 March 2016
• Author: Jianhui Huang,Ling Liu,Ingrid C. Ulstad
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

Growth options and relative

performance evaluation

Jianhui Huang

Corporate Executive Board, Singapore, Singapore, and

Ling Liu and Ingrid C. Ulstad

Accounting and Finance, University of Wisconsin-Eau Claire, Eau Claire,

Wisconsin, USA

Abstract

Purpose – The purpose of this study is to investigate the cross-sectional associations between growth

options and the peer pay–performance sensitivity of CEO compensation.

Design/methodology/approach – This study includes analytical analysis and multivariable

regression analysis.

Findings – It is predicted in this study that there is a non-linear concave relation between peer pay–

performance sensitivity and a rm’s growth options. Results based on the executive compensation data

from ExecuComp are consistent with the hypothesis presented in this study.

Research limitations/implications – Future scholars need to consider the non-linear impact of

growth options on peer pay–performance sensitivity when they conduct research related to CEO

compensation by differentiating the company’s growth options to be at a low, medium and high level.

In an industry, when a compensation committee decides on the peers for performance comparison

purposes, the committee needs to make sure that the peer rms they select have similar operational

environments, for example, they face similar growth options (e.g. low, medium or high) and

idiosyncratic variances.

Practical implications – This study contributes to the managerial compensation literature by

revealing the important role growth options, as well as idiosyncratic variances, play on peer pay–

performance sensitivity. The results of this study have implications for both future researchers as well

as industrial practitioners.

Social implications – It gives guidance on designing CEO compensation contracts.

Originality/value – This is an original work from the coauthors listed on this study.

Keywords Relative performance evaluation, Growth options, Idiosyncratic variance,

Non-linear relation

Paper type Research paper

1. Introduction

In the context of relative performance evaluation (RPE), CEO compensation is

determined by the performance of the rm as well as the performance of its peer

group. Such a linkage can insulate a CEO’s compensation from shocks outside of his

or her control and provide incentives to put forth maximum effort (Holmstrom, 1979,

1982). For example, Hao et al. (2014) nd that rms that have more connected board

members and whose board members are connected to better-connected rms are

more likely to reward their CEOs contingent on their peers’ performance. Mohan and

Fall Ainina (2012) nd that the average fair value of stock awards is high, and the

The current issue and full text archive of this journal is available on Emerald Insight at:

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IJAIM

24,1

38

Received 4 October 2014

Revised 9 December 2014

Accepted 10 December 2014

InternationalJournal of

Accountingand Information

Management

Vol.24 No. 1, 2016

pp.38-55

©Emerald Group Publishing Limited

1834-7649

DOI 10.1108/IJAIM-10-2014-0067

average fair value of option awards is low after 2004, which suggests that

companies may substitute restricted stock for options to increase the total executive

pay. However, does the effectiveness of RPE depend on rm-specic characteristics,

such as a rm’s growth options? If so, then what will be the relationship? As noted

in previous literature (Baber et al., 1996), the structure of executive compensation is

determined by various rm characteristics, for example, growth options that

inuence contractual relationships among parties within a rm. Answering the

above question will aid boards of directors in designing the right incentive plans

based on rm-specic characteristics, such as growth options and idiosyncratic

variance. Hence, in this paper, we investigate the relationship between a rm’s use

of RPE and its level of growth options.

Dye (1992) proposes that it is more likely for those rms with sufciently small or

sufciently large project choices to implement RPE to compensate their executives.

For rms with moderate project choices, adopting RPE will wrongly incentivize

CEOs to choose projects for which their relative talent is the greatest in comparison

to their peer rivals at other rms, instead of picking those projects for which they are

absolutely most talented. Recall that under a RPE compensation scheme, a CEO is

paid more if he or she leads a rm to achieve better nancial and/or stock

performance than its rivals. In such a circumstance, this CEO will be motivated to

choose the project for which he or she is relatively most talented. However, because

shareholders are compensated by the absolute output levels, they prefer the CEO to

choose the project for which he or she is absolutely most talented. Hence,

implementing a RPE for the CEO of a rm with moderate project choices will result

in a misalignment between the best interests of the CEO and the shareholders. To

summarize, Dye’s (1992) analytical models predict that there is a non-linear concave

relationship between the number of project choices a rm has and its likelihood of

using RPE.

It is reasonable to assume that rms with high growth options also have a high

number of project choices. Hence, based on the executive compensation data and built

upon the analytical model results of Dye (1992), we show that for CEO compensation,

peer pay–performance sensitivity increases at a decreasing rate with respect to the

rm’s growth options. In addition, we show that such a concave non-linear relationship

between peer pay–performance sensitivity and growth options is moderated by the

rm’s idiosyncratic variance.

This paper contributes to the compensation literature by revealing that the level of

RPE across rms varies with a rm’s level of growth opportunities in a non-linear

fashion. This might partially explain the lack of empirical evidence for RPE in prior

research. Previous research has studied the signicance of growth options on rm pay–

performance sensitivity (Baber et al., 1996). In contrast, we focus on the sensitivity of

compensation to peer performance measures with respect to growth options. Our results

add to the literature on how RPE usage varies with rm-level characteristics, for

example, growth options as well as idiosyncratic variance.

The paper proceeds as follows. Section 2 develops our hypothesis. Section 3 describes

our model specications and variable denitions. Section 4 tests the relationship

between the use of RPE and a rm’s growth options. Section 5 discusses the ndings and

their implications and provides some concluding remarks.

39

Relative

performance

evaluation