Are CEOs Underpaid?

Do we pay top executives too little? That, as Tyler Cowen points out, is the question raised by a recent paper by Bang Dang Nguyen and Kaspar Meisner Nielsen. The Institute for Policy Studies found the CEOs of S&P the companies on the S&P 500 made more than $9.2 million in 2009—263 times as much as the average worker. But according to Nguyen and Nielsen’s paper, considering what good CEOs are worth to corporations, that still may not be enough.

Nguyen and Nielsen are not suggesting that top executives are inherently 263 times more productive than the average person. If the top CEOs are worth that much money, it’s because as the heads of big corporations they are highly leveraged. With that much money under their control, in other words, they only need to be a little bit better than their potential replacement to be worth a lot more money.

It’s certainly not out of the question that for big companies the difference between a good CEO and an ordinary CEO could be millions of dollars on average.To find out what top CEOs are really worth, Nguyen and Nielsen looked at the effect the sudden death of the CEO had on the market value of the company. The idea is that the fall in the stock price after then news of its CEO’s death should reflect how much the market thinks the CEO is worth. On average, Nguyen and Nielsen found that the sample of 149 CEOs that died suddenly between 1991 and 2008 made just 80% on average of what the market thought they were worth. In other words, far from being overpaid, the CEOs were actually worth substantially more to their companies than they were making.

If I were a CEO I would make precisely this argument. But there are reasons to be skeptical. One is that in around 40% of the cases Nguyen and Nielsen looked at stock prices actually rose after the death of the CEO, which suggests that the value of CEOs may vary widely, and that hiring a CEO who actually increases the value of your company may not be that easy. Another is that you would expect the stock price to fall some simply out of a concern that the sudden death of the CEO might throw a company’s operations into chaos, regardless of how good the CEO was.

But the larger reason to be skeptical is that it’s not clear the movement of companies’ stock prices necessarily reflect the CEO’s real contribution to the value of the company. As the first commenter on Cowen’s post remarked, you have to a lot of faith a strong version of the efficient-market hypothesis to think studies like this make sense. Just because the market acts as if the CEO is worth that much doesn’t mean they actually are. It only means that the market agrees with corporate management’s assessment of the CEO’s worth.

The standard reply to this kind of skepticism about market valuations is to ask why, if the market is getting the value of a company wrong, smart traders don’t bet against the rest of the market and make money. But the fact is in the near-term market expectations can be self fulfilling. As I have argued before, traders can make a lot of money just by agreeing with the conventional wisdom. And anyone who bets against the market as a whole can wait a long time before their bets ever pay off. To pretend otherwise is to deny the existence of bubbles like the one that just brought down the economy. In the wake of the subprime crisis, it really is time we stopped reflexively assuming that the market is always right.