Managerial Discretion Affects Board and Shareholder Reactions to Information about CEO Quality

Managerial Discretion
Managerial Discretion Affects Board and Shareholder Reactions to Information about CEO Quality • (iStockphoto)
June 13, 2012

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WACO, Texas (June 13, 2012) - A company's share price and its CEO's compensation can be influenced by third-party endorsements of the CEO, as well as the strategic options, called managerial discretion, that executives have at their disposal to manage the company, according to a study recently published in the Journal of Business Research.

The article currently is available online by clicking here.

Study findings indicate that company boards reward endorsed CEOs with higher compensation when those individuals benefit from a wide range of strategic options, but not when those individuals have access to a constrained set of strategic options. In contrast, shareholders, regardless of managerial discretion levels, positively respond to CEO endorsements in the short term by bidding up the share price, although these responses become more equivocal over time.

"These results suggest that, at least in the short term, directors more adeptly interpret and respond to external information about CEO quality than shareholders," said Theodore L. Waldron, Ph.D., assistant professor of management and entrepreneurship at Baylor University's Hankamer School of Business and co-author of the study. "Contrary to popular depictions of directors as mindless puppets for CEOs, the former seems to draw actively and independently on multiple sources of information when evaluating the latter's ability and worth."

Other authors are Scott D. Graffin, Ph.D., assistant professor of management, Terry College of Business at the University of Georgia; Joseph F. Porac, Ph.D., George Daly Professor of Business Leadership, Leonard M. Stern School of Business at the New York University; and James B. Wade, Ph.D., Asa Griggs Candler Chaired Professor of Organization and Management, Goizueta Business School at Emory University.

The study found that shareholders, conversely, quickly overreact to positive news about a CEO and then make extreme valuation corrections over time.

"For instance, the investors of high-discretion firms develop unattainable performance expectations for publicly lauded CEOS and their firms," Waldron said. "When these expectations inevitably are not met, shareholders eventually become dissatisfied and drastically reduce share prices. Surprisingly, the investors of low-discretion firms develop even stronger short-term expectations when their CEOs receive public accolades, which might result from surprise that executives with less latitude to influence their firms' performance would receive recognition for managerial prowess. These findings support the idea that investors are irrationally exuberant."

The study looked at 255 companies that were members of the S&P 500 at the end of 1993. There were no significant differences between the sample and the S&P 500 based on size, performance, and industry representation. Firms in the sample varied considerably in size, ranging from $181 million to $272 billion in assets. Data were gathered from 1993 to 1996.

The data to measure third-party endorsements of CEO quality were taken from Financial World magazine's "CEO-of-the-Year"--one of the most systematic and comprehensive contests of its type to date. Financial World annually surveyed business analysts and CEOs who rated CEOs on four criteria:

(1) During the preceding year, this corporate chief so managed his company's affairs that it was among the leaders in standard analytic measurement tools of performance. Given the limitation of the economy in general and his industry in particular, his company was able to effect a high rate of return on investment capital, a big increase in net income, best management of debt, etc.

(2) The executive so managed his company that it increased its position in the field significantly or maintained its position in spite of general adversity.

(3) This chief executive has assembled an effective working team to surround him so that corporate affairs are run smoothly with creativity, innovation and dynamism. Morale in his company is high in response to his leadership.

(4) This chief executive has not only been responsible for input into his company but has contributed significantly to his industry and/or community and the nation at large.

"Our study's main practical contribution is straightforward, yet powerful: managerial discretion can indeed modify how boards and investors incorporate CEO endorsements into executive compensation and firm valuation decisions," Waldron said. "Perhaps directors can more explicitly incorporate managerial discretion into other important governance decisions such as hiring, retention, and termination that similarly depend on the evaluation of information about CEO quality.

"In contrast, investors' overreactions to CEO awards imply that shareholders do not consider managerial discretion as heavily as boards. Additional attention to discretion levels may help investors to temper their short-term exuberance and long-term pessimism about endorsed CEOs' effects on firm outcomes," he said.


Baylor University is a private Christian university and a nationally ranked research institution, classified as such with "high research activity" by the Carnegie Foundation for the Advancement of Teaching. The university provides a vibrant campus community for approximately 15,000 students by blending interdisciplinary research with an international reputation for educational excellence and a faculty commitment to teaching and scholarship. Chartered in 1845 by the Republic of Texas through the efforts of Baptist pioneers, Baylor is the oldest continually operating university in Texas. Located in Waco, Baylor welcomes students from all 50 states and more than 80 countries to study a broad range of degrees among its 11 nationally recognized academic divisions.


Baylor University's Hankamer School of Business provides a rigorous academic experience, consisting of classroom and hands-on learning, guided by Christian commitment and a global perspective. Recognized nationally for several programs, including Entrepreneurship and Accounting, the school offers 24 undergraduate and 13 graduate areas of study.

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