MANAGEMENT SCIENCE informs ®

Vol. 56, No. 10, October 2010, pp. 1633–1652 doi 10.1287/mnsc.1100.1205
issn 0025-1909
eissn 1526-5501
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5610
1633 © 2010 INFORMS

CEO Ability, Pay, and Firm Performance

Yuk Ying Chang
School of Economics and Finance, College of Business, Massey University, Wellington 6021, New Zealand,
y.chang@massey.ac.nz

Sudipto Dasgupta
Department of Finance, Hong Kong University of Science and Technology, Clear Water Bay,
Kowloon, Hong Kong, dasgupta@ust.hk

Gilles Hilary
Department of Accounting, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong;
and Department of Accounting, HEC Paris, 78350 Jouy-en-Josas Cedex, France, acgh@ust.hk

D o chief executive officers (CEOs) really matter? Do cross-sectional differences in firm performance and CEO
pay reflect differences in CEO ability? Examining CEO departures over 1992–2002, we first find that the
stock price reaction upon departure is negatively related to the firm’s prior performance and to the CEO’s prior
pay. Second, the CEO’s subsequent labor market success is greater if the firm’s predeparture performance is
better, the prior pay is higher, and the stock market’s reaction is more negative. Finally, better prior performance,
higher prior pay, and a more negative stock market reaction are associated with worse postdeparture firm
performance. Collectively, these results reject the view that differences in firm performance stem entirely from
non-CEO factors such as the firms’ assets, other employees, or “luck,” and that CEO pay is unrelated to the
CEO’s contribution to firm value.
Key words: CEO ability; CEO pay; managerial labor market; firm performance
History: Received January 14, 2009; accepted May 11, 2010, by Wei Xiong, finance. Published online in Articles
in Advance August 20, 2010.

1. Introduction CEOs are in fact in a unique position to entrench

Do chief executive officers (CEOs) really matter?
Does CEO ability have any effect on firm value,
performance, and CEO pay? A large literature takes
the relevance of CEO ability as given; for exam-
ple, the distribution of CEO talent in the economy
provides the theoretical underpinnings for the tal-
ent assignment models of Rosen (1982) or Gabaix
and Landier (2008). Yet, a plausible alternative view
is that the firm’s performance is largely determined
by the nature of its core competence, the quality of
its products, other employees and stakeholders, its
life cycle, and even possibly by luck. According to
this view, CEO ability is relatively unimportant for
firm value. Collingwood (2009, p. 3), for example,
reports that “James March, a management professor
at Stanford, goes so far as to say that in any well-
run company that’s conscientious about grooming its
managers, candidates for the top job are so similar in
their education, skills, and psychology as to be virtu-
ally interchangeable. All that matters is that someone
be in charge.” Collingwood (2009, pp. 1, 2) further
wonders, “How much difference can a CEO make,
anyway? The answer doesn’t seem as obvious today
as it did a few years ago.” An even more cynical view
is that, far from meaningfully increasing firm value,
1633
themselves and extract “rents.” Shleifer and Vishny
(1989) argue that managers can entrench themselves
by making manager-specific investments that make
it difficult for shareholders to replace them. Bebchuk
and Fried (2004) argue that CEOs can easily capture
their boards and essentially set their own pay. Pay,
according to this view, is determined more by man-
agerial power than by ability.
The recent financial crisis and the storm over the
pay of executives in financial firms have brought the
question of whether CEOs meaningfully add value to
the companies they manage, and whether their pay
reflects ability or rent extraction, into even sharper
focus. However, although these questions are central
ones, empirical resolution of these issues has been dif-
ficult. The main problem is that CEOs are not ran-
domly assigned to firms, and isolating CEO attributes
from firm attributes is difficult, particularly in a
purely cross-sectional study. One of the best oppor-
tunities to do so is to study the change in a firm’s
market value and performance around a CEO change.
The financial market’s reaction to the news of a CEO’s
departure is one way to gauge the contribution of
that CEO relative to a potential replacement. If CEO
pay and firm performance reflect CEO ability, then
 Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
1634
the financial market’s reaction to the departure news
should be related to the pay and performance prior
to departure. Prior pay and performance should also
be related to the external labor market’s perception
of managerial ability (as measured by the subsequent
labor market progress of the manager), and the subse-
quent operating performance of the firm that loses the
CEO. To test these predictions, we study a sample of
298 CEO departures (both voluntary and forced) over
the 1992–2002 period, and consider evidence from the
financial and labor markets and directly from firm
performance after the CEO departure.
First, we hypothesize that if financial markets did
not attribute differences in prior firm performance to
differences in CEO ability, there would be no associa-
tion between the firm’s performance under the CEO’s
management and the stock price reaction to the news
of the CEO’s departure. In contrast, if the financial
market attributes performance differences to differ-
ences in the CEO’s managerial ability, one should
observe a negative relationship. Similarly, if CEO pay
is unrelated to either the CEO’s managerial ability
or to the CEO’s ability to extract rents (the so-called
“skimming” view), there should be no association
between the pay and the stock market’s reaction to the
departure news. We focus on the “relative” pay of the
CEO in relation to the pay of the other four highest-
paid executives in the company to filter out the effect
of potentially unobserved factors that affect the pay
levels of top executives in a company. Thus, if higher
relative pay is associated with a more negative stock
price reaction, the null hypothesis is rejected in favor
of the managerial ability hypothesis; if the associa-
tion is positive, it is rejected in favor of the skimming
hypothesis. Our empirical results are consistent with
the financial market’s associating prior performance
and CEO pay with the CEO’s managerial ability.
A one-standard-deviation increase in prior three-year
industry-adjusted buy-and-hold stock returns leads
to a 1.4% decrease in abnormal stock return (from
one day before to seven days after the departure
announcement). A one-standard-deviation increase in
our relative pay measure leads to a 2.7% decrease in
the abnormal stock return.
Next, we examine whether prior firm performance
and CEO pay are related to the CEO’s success in
the managerial labor market. Given that the stock
market reaction is consistent with the recognition
of CEO ability, we hypothesize that more negative
abnormal returns are associated with better labor
market progress. In addition, if differences in prior
performance and relative pay reflect variations in
CEO ability, the CEO’s labor market progress should
be better when the prior performance is stronger,
and the prior relative pay higher. We classify labor
market progress on the basis of whether the CEO
Management Science 56(10), pp. 1633–1652, © 2010 INFORMS
finds another managerial appointment and whether
the CEO is better paid in the new job or ends
up in a bigger firm. Our results strongly support
the managerial ability hypothesis. A one-standard-
deviation increase in the prior three-year buy-and-
hold returns, increase in our measure of relative pay,
and decrease in residual abnormal returns (i.e., the
part of abnormal announcement returns unexplained
by prior performance and pay) increase the probabil-
ity of successful labor market progress by 10%, 8%,
and 6%, respectively.
Examination of the stock market’s response is very
informative about a CEO’s contribution to firm value
when there are no confounding contemporaneous
announcements, because the market reacts to the
news of the departure alone. The labor market out-
comes are also especially informative because the pro-
cess of selection and recruitment is likely to assign
significant weight to managerial attributes that are
observable to the recruiter but not to the researcher.
However, as Huson et al. (2004, p. 239) note, “stock
price reactions around the time of management
turnover reflect investors’ expectations regarding these
outcomes, but do not reveal the outcomes them-
selves.” Perception, rather than actual ability, could
also be relevant for the managerial labor market.
To investigate whether actual or perceived ability
explain the results from the stock and labor mar-
kets, we also examine whether the firm’s post-CEO-
departure performance is related to the prior per-
formance, relative pay, and abnormal returns around
the announcement date. Consistent with the manage-
rial ability hypothesis, the firm’s industry-adjusted
operating performance one or three years after the
departure is worse if the prior stock performance is
better, the CEO’s relative pay is higher, and the abnor-
mal stock returns around the departure announce-
ment date are lower. We find similar results for the
firm’s stock market performance over one to three
years after the departure. The results are economically
significant. A one-standard-deviation change in prior
three-year buy-and-hold returns, our measure of prior
relative pay, and residual abnormal returns is associ-
ated with an absolute change in the industry-adjusted
return on assets, from one year before to one year
after the departure, by 0.5%, 0.6%, and 0.8%, respec-
tively. Given that the mean and median industry-
adjusted return on assets for the calendar year prior
to the departure are 2% and 0.6%, respectively, these
magnitudes are substantial.
An important advantage of our three-pronged
approach is that even if alternative explanations could
be plausibly offered for any of the individual results,
it is difficult to offer one alternative explanation con-
sistent with all our results. For example, it might be
Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
Management Science 56(10), pp. 1633–1652, © 2010 INFORMS
argued that CEOs “jump ship” and quit voluntar-
ily when they expect future prospects to deteriorate
and are forced to quit (for example, as a result of a
governance change) when the prior performance is
poor. This may explain why prior performance is neg-
atively related to announcement returns and future
operating performance but not why managers’ labor
market progress should be positively related to past
pay. Such an explanation requires prior pay to be low
when performance is poor, quite the opposite of a
governance-change explanation. Two additional find-
ings further rule out this alternative explanation. First,
the departure announcement abnormal return of the
firm the CEO leaves and the appointment announce-
ment abnormal return of the new firm the CEO joins
are negatively and significantly correlated. This is
consistent with the notion that the market value of
the old firm will decrease more and that of the new
firm will increase more if the CEO’s ability is higher.
Second, the operating performance of the firm the
CEO joins improves more if the CEO’s relative pay in
the previous job is higher and the stock market’s reac-
tion to the departure news is more negative. For these
two tests, we are necessarily restricted to CEO moves
to publicly traded firms, which significantly reduces
the sample size. However, our results still support the
managerial ability hypothesis.
Our paper makes several contributions to the lit-
erature. First, we provide evidence that CEO ability
differences exist and affect firm value and perfor-
mance. Second, our results show that CEOs of higher
ability also receive higher pay, a finding that con-
trasts with those of Bebchuk et al. (2008).1 Bebchuk
et al. (2008) find that, in a sample of firms in which
the managers are entrenched, the CEO’s pay rela-
tive to the pay of the four other highest-paid exec-
utives in the company is negatively associated with
firm performance. They interpret this as evidence that
high CEO relative pay represents rent extraction by
CEOs. In untabulated tests, we find that CEO rela-
tive pay is no longer significant for a subsample of
departures with poor governance characteristics, as
measured by the G-Index (Gompers et al. 2003). How-
ever, our results are stronger, both economically and
statistically, in the complementary subsample of firms
with good governance characteristics. These results
1
We recognize that because our results are based on a sample
of CEO turnovers, we need to be cautious in this interpretation.
It is possible that the CEOs who are strongly entrenched very sel-
dom quit. Thus, our sample may consist mostly of high-quality
CEOs and low-quality CEOs who are not entrenched. If true, the
number of entrenched low-quality CEOs may be lower in our sam-
ple than in the overall population. However, the median entrench-
ment index for firms in Bebchuk et al. (2009) sample is identical to
that in ours over the same sample period, suggesting that we are
not capturing turnovers of less-entrenched managers.
1635
suggest that governance does matter for the pay-
performance relationships.
The rest of this paper is organized as follows.
Section 2 reviews the prior literature. Section 3 dis-
cusses the data and our sample. Section 4 develops
the testable hypotheses. Section 5 reports the empiri-
cal results. Section 6 concludes the paper.
2. Related Literature
Our study is related to several lines of research.
One of our main objectives is to design tests that can
identify cross-sectional differences in CEO ability rele-
vant for firm value and performance. To identify such
evidence, we rely on a sample of CEO turnovers and
focus on three variables that potentially correlate with
CEO ability: one is the abnormal stock price reaction
around the CEO departure announcement, the second
is the firm performance prior to the CEO departure,
and the third is the relative pay of the CEO. We then
examine how the last two of these variables relate to
the stock market reaction around the CEO turnover
announcement, and how all three relate to the success
of the departing CEO in the managerial labor market,
and the subsequent performance of the firm losing
the CEO. We organize our discussion of the relevant
literature around these key points.
2.1. Cross-Sectional Differences in CEO Ability
The empirical literature on this topic is fairly limited,
but there is support for the idea that these differences
exist and matter. For example, Lieberman et al. (1990)
find significant CEO fixed effects on productivity in
the U.S. and Japanese automobile industries. Bertrand
and Schoar (2003) find that CEOs have different man-
agerial styles that are carried as they go from one firm
to another. They provide evidence that these differ-
ences matter for a wide range of corporate decisions.
They also suggest that management styles appear to
be related to performance and pay. Our tests, in con-
trast, are specifically tailored toward relating prior
performance and pay to financial and labor market
outcomes and operating performance changes when a
CEO leaves the firm. Moreover, because our primary
source of identification of CEO changes is the Execu-
Comp database, which starts in the year 1992, we do
not have a sufficiently long panel to reliably identify
managerial fixed effects.
2.2. Market Reaction to Managerial
Departures or Sudden Deaths
Several studies examine the stock market’s reaction to
the news of managerial departures or sudden deaths.
The earlier papers find mixed evidence. Most of these
results do not distinguish between voluntary and
involuntary turnovers. Reinganum (1985) considers
 Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
1636
changes in the position of president and/or chair-
man and finds no systematic reaction around the
announcements of the executive departures. Warner
et al. (1988) consider a sample of CEO departures.
They do not find any significant market reaction at
the announcement either in their overall sample or in
the sample of forced departures.2 In contrast, several
more recent studies find an effect on the stock price.
Khanna and Poulsen (1995) find a negative average
announcement effect for managerial replacements in
firms that eventually sink into financial distress. Denis
and Denis (1995) find a significant positive effect for
forced turnovers. Hayes and Schaefer (1999) look at
returns around the announcement dates for a sample
of CEO-to-CEO moves and non-CEO-to-CEO moves,
and they compare the announcement returns with
those for a control sample of CEO deaths. They find
that for the former sample, abnormal returns average
−1
51%, compared to 3.82% for the latter.3
Johnson et al. (1985) and Nguyen and Nielsen
(2010) study abnormal returns around unexpected
deaths of top executives. A major advantage of this
approach is that, unlike forced CEO changes, there
are unlikely to be many other types of concurrent
events or announcements that would confound the
announcement period returns, and unlike retirements,
the event is not likely to be anticipated.4 Johnson
et al. (1985) find that there is no average effect over-
all, but the abnormal returns are lower for firms with
higher CEO pay and prior performance. Nguyen and
Nielsen (2010) find that the pay of the executive is
negatively related to the abnormal return around the
announcement of the executive’s death. Nguyen and
Nielsen (2010) also determine that executives keep
around 80% of the value they create. Our tests on the
stock market’s reaction to departure news extend the
results of the above studies to a sample of CEO depar-
tures that are not sudden-death events. One advan-
tage of studying CEOs who stay alive is that we can
use their subsequent labor market performance as an
additional measure of ability.
2
Reinganum (1985) finds a small positive reaction in the sample of
firms in which the chairman is replaced by an outsider (10 cases).
Warner et al. (1988) find a small positive effect in the subsample of
outside successions.
3
Hayes and Schaefer (1999) find that the more negative the
announcement effects, the larger is the ratio of assets of the new
firm to the old firm, consistent with the implication of assignment
models (Rosen 1982, Gabaix and Landier 2008) that suggest that
more capable managers are likely to move to bigger firms. They
also find that abnormal returns for firms that lose top managers
and those that hire the same individuals as CEOs are weakly neg-
atively related, suggesting that the loss to one firm is related to the
gain to the other.
4
See Warner et al. (1988) and Denis and Denis (1995) for discussions
of the difficulty of interpreting event study results around CEO
turnovers.
Management Science 56(10), pp. 1633–1652, © 2010 INFORMS
2.3. Prior Performance and Labor
Market Outcomes
Fee and Hadlock (2003) study whether the prior per-
formance of a firm affects the probability that a top
executive in that firm will be “raided” by another
firm. The main finding is that firms that outperform
their benchmarks are likely to lose their executives to
CEO positions elsewhere. Fee and Hadlock (2004) find
that executives leaving S&P 500 firms do not typically
do well, and seem to move to inferior jobs, in terms
of both relative firm size and relative pay.5 In con-
trast to these studies, we rank the CEOs in terms
of their subsequent labor market success and try to
examine whether the prior performance, the CEO’s
relative pay, and the stock price reaction to the depar-
ture announcement predict the degree of success in
the managerial labor market.
2.4. Postdeparture Performance
Firm performance change after CEO turnover is
potentially an important way to identify the value
of a CEO to the firm. Denis and Denis (1995) find
that forced resignations of top managers are preceded
by large and significant declines in operating perfor-
mance and followed by large improvements in per-
formance, whereas normal retirements are followed
by smaller improvements in operating performance.
Huson et al. (2004) show that operating performance
deteriorates prior to a CEO turnover and improves
subsequently, and that these effects are strongest for
forced turnovers. Of particular relevance to our anal-
ysis, the two-day announcement period abnormal
returns around CEO turnover are positively related
to the change in operating performance. These results
suggest that price reaction around the CEO departure
announcement can be a proxy for the value of the
CEO. However, one concern with studies of firm per-
formance around CEO turnover is that, like studies of
announcement effects, identification of a CEO effect
can be confounded by the nature of circumstances
that caused the turnover. Bennedsen et al. (2009), like
Johnson et al. (1985), study sudden deaths of CEOs
and their family members to avoid this identification
problem. They find that CEO deaths are strongly cor-
related with declines in operating profitability, asset
growth and sales growth. Unlike the above studies,
our tests explicitly link postdeparture performance
to the three variables that potentially reflect CEO
ability—the prior performance of the firm under the
CEO’s management, the relative pay of the CEO, and
the stock market’s reaction to the departure news—for
a sample of CEO departures that include both volun-
tary and forced turnovers and are not sudden-death
events.
5
Several papers examine what former CEOs do. See Brickley et al.
(1999) and Fahlenbrach et al. (2010).
Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
Management Science 56(10), pp. 1633–1652, © 2010 INFORMS
2.5. Compensation, Skill, and Entrenchment
The issue of whether differences in CEO pay reflect
differences in ability or in power is one of the most
contentious issues in academic and policy circles.
Some authors have argued that the compensation of
U.S. executives is too high and too insensitive to
their performance (e.g., Bebchuk et al. 2002). Bebchuk
and Fried (2004) argue that many of the features of
CEO pay reflect that corporate insiders essentially set
their own pay. Bebchuk and Fried (2004) conclude
that higher CEO pay reflects skimming by entrenched
CEOs rather than talent. Others, however, argue that
most available evidence is consistent with the efficient
contracting view (Edmans and Gabaix 2009 provide
a survey of the theoretical literature on the efficient
contracting view). Based on a model in which agents
gradually learn about CEO ability, Taylor (2010) esti-
mates that CEOs capture only 20%–33% of the surplus
resulting from good news, and they bear 8%–20% of
the negative surplus resulting from bad news, and the
difference is not statistically significant.
3. Sample
3.1. Departure Sample
We compile a sample of CEOs who left their jobs
before the age of 61 (to minimize the possibility that
the departure is a retirement) using two databases: the
Annual Compensation Surveys published in Forbes
(covering the period from 1992 to 2000) and Compu-
stat’s ExecuComp database (covering CEOs of com-
panies in the S&P 500, the S&P MidCap 400, and
the S&P SmallCap 600 from 1992 through 2002).6
In addition to the availability of proxy statements
around the time of the CEO departure, we also
require that the announcement be recorded in the
LexisNexis database. We use ExecuComp to iden-
tify changes in the identity of the CEO of a firm
from one year to another. For firms included in the
Forbes surveys, we have information on the length
of the CEO’s tenure, and we can identify firm years
where the CEO had been in that position for no
more than one year, indicating a recent CEO turnover.
For each CEO turnover, we search LexisNexis or
6
The ExecuComp database includes active and inactive firms in
the S&P 1500 index. The data is available from 1992. The S&P
1500 firms are operating U.S. companies whose stocks are widely
available to investors and are highly liquid. The firms included in
the Forbes Annual Compensation Survey are the 800 biggest com-
panies in the United States (“as measured by a composite rank-
ing of sales, profit, assets, and market value” (Forbes 2001)). We
find 27 cases in which the old firm in the sample of CEO depar-
tures is included in the Forbes surveys, but does not appear in the
ExecuComp database. For example, Hill Department Stores, DQE
Holdings Inc., and Continental Airlines are included in the Forbes
surveys, but do not appear in the ExecuComp database.
1637
the proxy statement for information on the incom-
ing CEOs and identify the firms where they were
previously employed. If an incoming CEO was the
CEO of another company not already included in our
sample, this gives us an additional case of a CEO
departure. We then retrieve information from proxy
statements on the length of the CEO’s tenure and
exclude cases in which the CEO tenure was less than
18 months. We collect compensation data from the
proxy statements.7 We eliminate observations where
the CEO change was caused by death or by merger
and acquisition activity. Finally, we exclude all cases
in which the departing CEO continued to have any
relationship with the company, such as chairman of
the board or consultancy agreements. As a result,
we identify 434 CEO departures. However, we lose
54 observations because we cannot compute cumu-
lative abnormal returns from day −1 to +7 around
the departure announcement as the companies are not
publicly traded, 67 additional observations because
we cannot compute three-year industry-adjusted buy-
and-hold returns, 10 observations because the rela-
tive pay of the CEO cannot be reliably computed,
and 5 observations because other variables used in
our regression specification are missing. This leaves
us with 298 CEO moves.
In addition, we identify 44 CEO death events for
the period from 1992 to 2002. As discussed in §2,
several studies examine unanticipated deaths of top
executives, because this is a very clean way to iden-
tify the effect of a CEO’s departure on a firm’s future
prospects. Because we cannot include these cases in
all our tests (as some of our tests require us to fol-
low the subsequent career progress of the CEO), we
exclude these cases completely in all results reported
in our tables. However, inclusion of these cases where
feasible does not affect our conclusions.
3.2. Comparison with Other Samples
One difficulty in putting together the results of pre-
vious studies on CEO movements discussed in §2 is
that they are often based on different samples, and
the extent to which findings are robust across all
such samples is not clear. Our sample brings together
within one framework several related hypotheses
about managerial ability and reputation formation
for managerial turnovers in a large cross-section of
firms. There are some important differences in sample
composition between our sample and those used in
prior studies. For example, we identify a total of 131
cases of CEO-to-CEO moves—a larger number than
the 24 cases identified by Hayes and Schaefer (1999),
7
Because the CEOs identified by this process were not all taken
from the ExecuComp database, we rely on compensation data from
proxy statements.
 Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
1638
the 43 cases in sample 1 of Fee and Hadlock (2003),
the 5 cases in sample 2 of Fee and Hadlock (2003),
and the 12 cases in Fee and Hadlock (2004). Huson
et al. (2004) study a sample of voluntary turnovers
and find a positive relationship between announce-
ment period abnormal returns and change in operat-
ing performance. However, their sample of voluntary
turnovers includes retirements, and the announce-
ment period abnormal returns are significantly posi-
tive. Therefore, it is unlikely to be a sample of depart-
ing CEOs with “above average” ability.
4. Hypothesis Development
In this section, we develop our testable hypotheses.
First, we discuss the three key dependent variables
corresponding to our three main tests. Next, we dis-
cuss the three explanatory variables that are the focus
of our main testable hypotheses.
4.1. Key Dependent Variables
4.1.1. Cumulative Abnormal Returns (CARs). In
our first test discussed below, we examine how the
stock market’s reaction to the departure news of
the CEO is related to CEO relative pay and prior
firm performance—variables that potentially corre-
late with CEO ability. The stock market’s reaction,
however, may have incremental information content
about CEO ability, perhaps reflecting more recent
news, not reflected in pay or performance. There-
fore, in our subsequent tests, we use the residual
from the cumulative abnormal return (CAR) regres-
sion of our first test (Equation (1) in §4.3.1) as an
additional measure of CEO ability. In the tabulated
regressions results, CARs are based on the market
model estimated over a period from 300 days before
to 30 days before the event date. All tabulated results
are based on CARs over the (−1 day, +7 days) win-
dow around the announcement date. However, as
we discuss below, our results are similar for CARs
over the (−1 day, +1 day) window (CAR−1 +1) as
well as for CARs based on the Fama-French three
factor model (Fama and French 1993) over both the
−1 +1 and −1 +7 windows (FFCAR−1 +1 and
FFCAR−1 +7, respectively).
4.1.2. Postdeparture Labor Market Progress. We
use the LexisNexis database to collect information
on the career progress of the departing CEO. After
identifying a CEO departure that meets our crite-
ria mentioned in §3.1, we search for an announce-
ment on any subsequent appointment taken up by the
departing CEO within three years of his departure.
We first create a two-way classification and then cre-
ate a four-way classification to see whether our results
are robust to a finer classification scheme.
The two-way classification considers labor market
progress as “unsatisfactory” if the CEO only takes up
Management Science 56(10), pp. 1633–1652, © 2010 INFORMS
new directorships or there is no information indicat-
ing that the CEO is appointed to any new managerial
position. Progress is considered to be “satisfactory”
for the rest of the CEOs, who end up with manage-
rial positions in other public or private companies. We
drop five cases in which the departing CEOs became
politicians or educators. The inclusion of these cases
in any particular category has no material impact on
our results.
In our four-way classification, we further parti-
tion and order the unsatisfactory group as follows.
A CEO is classified as having experienced very poor
progress and given rank 1 if there is no information
indicating that he is appointed to any new position
(223 cases, 51%). He is classified as having experi-
enced “poor progress” and given rank 2 if he takes up
only new directorships (33 cases, 8%). The satisfactory
progress group is also partitioned into two groups.
A CEO is classified as having made “good progress”
and given the highest rank of 4 if any of the follow-
ing criteria hold: (i) the CEO ends up as the CEO of
another public company and either has a new salary
that exceeds his old salary8 or joins a company that is
larger in size (following Gabaix and Landier 2008 and
Edmans et al. 2009, we define size as the market value
of equity plus the book value of debt)9 than his old
company (49 cases);10 (ii) the CEO ends up as a non-
CEO executive of another company and has a higher
salary than in his old company (6 cases); or (iii) the
CEO joins a private company as a CEO within one
year (17 cases). This gives us 72 cases (17%) of good
progress. The remaining CEOs are classified as hav-
ing made “moderate progress” (106 cases, 24%) and
assigned a rank of 3.11
Panel A of Table 1 reports subsequent employment
details for the good progress and moderate progress
groups. Not surprisingly, most of the good progress
8
New salary is the dollar value of the base salary (including both
cash and noncash elements) earned during the first full fiscal year
under the new appointment. Old salary is the dollar value of the
base salary earned during the last full fiscal year under the old
appointment.
9
Specifically, we define size as Compustat item data199 × data25 +
data6 − data60 − data74.
10
Only in four of these cases was the salary criteria satisfied, but
not the size one. As an alternative, we completely ignored the size
and salary criteria, and good progress was defined on the basis
of higher pay at the new company, where pay includes salary,
bonus, total value of restricted stock granted, total value of stock
options granted, and all other compensation. Our results did not
change qualitatively, and all variables of interest remained statisti-
cally significant.
11
Panel A of Table 1 reports the career progress of CEOs in our
initial sample of 434 CEO moves. For our labor market progress
regressions, we have 298 cases that satisfy all the data require-
ments. For this sample, the distribution of “progress” is 17% good,
23% moderate, 7% poor, and 53% very poor.
Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
Management Science 56(10), pp. 1633–1652, © 2010 INFORMS 1639

Table 1 CEO Career Progress cases are CEO appointments in the new company.
Panel B of Table 1 reports summary statistics on new
Panel A: Postdeparture career progress
salary in relation to old salary and the size of the new
Moderate Good company in relation to that of the old company for
progress progress the good progress group and the moderate progress
(Frequency) (Frequency) group when the new company is a publicly traded
company. For the good progress group, the salary in
Top manager at another public company
the new company is 47% (41%) higher if we consider
Chairman, CEO, and president 5 9
Chairman and CEO 14 16
the mean (median) salary ratio. The new company
CEO and president 17 23 is bigger—six times larger if we consider the mean
CEO 5 1 size ratio and 72% larger if we consider the median.
Chairman 10 0 For the moderate progress group, the salary is 34%
Vice chairman, chief accounting 0 1 (28%) lower if we consider the mean (median) salary
and financial officer ratio. Size is 60% larger (30% smaller) if we consider
Vice chairman 1 0
Chief operating officer and 0 1
the mean (median) size ratio.
executive vice president 4.1.3. Postdeparture Change in Performance. To
Chief operating officer 0 1 examine how the performance of the firm changes
Chief financial officer and 0 2
after the departure of the CEO, we consider an
executive vice president
President 3 1 operating performance measure.12 In particular, we
Group vice president 2 0 examine the change in industry-adjusted return on
Senior vice president 1 0 assets (ROA) from the year before to the first or the
Vice president 2 0 third year after the year of the managerial depar-
Senior advisor 1 0 ture (ROA1 or ROA3). ROA is adjusted by sub-
Top manager at a private company tracting the contemporaneous median measure for all
Chairman, CEO, and president 3 1 non-CEO-turnover firms with the same two-digit SIC
Chairman and CEO 8 5 code. To facilitate comparison between the regres-
CEO and president 7 6
sions of ROA1 and those of ROA3, we calculate the
CEO 6 5
Chairman 10 0 annualized change in industry-adjusted ROA.13
Vice chairman 2 0
President 2 0 4.2. Key Explanatory Variables
Vice president 1 0
4.2.1. CEO’s Relative Pay (COMP). The pay of
Advisor 2 0
Partner 4 0 the CEO relative to that of the other top executives
of the company could potentially measure the CEO’s
Panel B: New vs. old positions ability or CEO power. Bebchuk et al. (2007, p. 1)
Moderate progress Good progress term this variable CEO centrality and point out that
it “might reflect the relative significance of the CEO in
Median Mean Median Mean
terms of abilities, contributions, and power. A greater
New salary ÷ old salary 0
7243 0
6659 1
4100 1
4782 relative significance of the CEO might come from
New employer’s size 0
6978 1
6019 1
7226 6
4310 being a ‘star CEO’—the CEO having (or being per-
÷ old employer’s size ceived as having) superior talents or qualifications
Notes. Panel A reports the postdeparture career progress of the departing that enhance the CEO’s relative contribution to the
CEOs. Panel B compares the departing CEO’s salary in his new and old posi- firm, as well as outside opportunities.” However, as
tions and the size (data199 × data25 + data6 − data60 − data74 using Com- these authors point out, higher CEO relative pay
pustat data) of the new and old firms. The good progress category comprises
could also reflect skimming or CEO entrenchment.
CEO departures that meet any of the following three conditions: (i) the CEO
ends up as the CEO of another public company within three years of the We use three alternative measures of the CEO’s rel-
departure and either has a new salary that exceeds his old salary or joins ative pay (COMP). All three measures consider the
a company that is larger in size (market value of equity plus book value of CEO’s pay in relation to the pay of the other four
debt) than his old company; (ii) the CEO ends up as a non-CEO executive
of another company within three years of the departure and has a higher
12
salary than in his old company; or (iii) the CEO joins a private company as a Operating performance measures have been used in the previ-
CEO within one year. The moderate progress category includes the remaining ous literature to study CEO turnovers (e.g., Denis and Denis 1995,
departing CEOs who take up a managerial position in another private or pub- Hotchkiss 1995, Huson et al. 2004).
13
lic company within three years of the departure and meet none of the three Specifically, for ROA1, we divide the difference between the
good progress conditions. New salary is the dollar value of the base salary industry-adjusted ROA for the year t + 1 and that for the year t − 1
(including both cash and noncash elements) earned during the first full fiscal by two whereas for ROA3, we divide the difference between the
year under the new appointment. Old salary is the dollar value of the base industry-adjusted ROA for the year t + 3 and that for the year t − 1
salary earned during the last full fiscal year under the old appointment. by four.
 Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
1640
highest-paid executives in the company. It is impor-
tant to benchmark the CEO’s pay against that of the
other highest-paid executives in the company because
executive pay in a company is likely to depend on
unobservable factors, and this type of benchmarking
partially filters out the effect of such factors on the
CEO’s pay. For example, a company may have a high-
pay policy for its top executives, and a higher abso-
lute pay for the CEO in such a company need not
necessarily identify an especially capable CEO.
Our first pay measure, relative_total_pay, is sim-
ply the ratio of the CEO’s total pay to the total
pay of the four other highest-paid executives in the
company over the last three full fiscal years before
the CEO’s departure, and is similar to the Bebchuk
et al. (2008) CEO-centrality measure.14 The second
measure, abnormal_CEO_pay, is the three-year prede-
parture average of the residual from a regression in
which the CEO’s total pay over a full fiscal year
is the dependent variable, and the explanatory vari-
ables include the sum of the total pay of the four
other highest-paid executives in the same company,
sales growth, total assets, year, and industry indi-
cator variables. We include total assets and sales
growth because the scale of a firm’s operation has
been consistently found to be one of the most sig-
nificant determinants of CEO compensation in earlier
studies. There is also evidence that CEO pay is sub-
ject to widespread benchmarking, so we also include
industry and year indicator variables to capture more
aggregative effects on CEO pay.15 The third measure,
abnormal_pay_difference, is the three-year predeparture
average residual from a regression in which the dif-
ference between the CEO’s total pay and the average
of the total pay of the four other highest-paid execu-
tives in the same company is the dependent variable,
and the explanatory variables include sales growth,
total assets, year, and industry indicator variables.
4.2.2. Prior Performance (BHAR and ROA). We
include two variables in our regressions to reflect
the performance of the firm under the CEO’s man-
agement prior to the CEO’s departure, BHAR and
14
Our pay measure is the same as TDC1 in the Execucomp
database. Total pay includes salary, bonus, total value of restricted
stock granted, total value of stock options granted (using S&P’s
modified Black-Scholes model), long-term incentive payouts, and
all other compensation. Because our sample of CEOs is not
restricted to firms in the S&P 1500, we obtain the primary informa-
tion from the proxy statements.
15
In the regressions for pay, the firm characteristics (sales growth
and total assets) are either marginally significant or not significant
at all—presumably, the pay of the other highest-paid executives
subsumes many firm characteristics that determine the pay level
in the company and is itself highly significant. Year and industry
indicator variables are also generally significant and explain a sub-
stantial part of the variation.
Management Science 56(10), pp. 1633–1652, © 2010 INFORMS
ROA. BHAR is the three-year industry-adjusted buy-
and-hold stock return (BHAR). Industry adjustment is
at the two-digit SIC level. As robustness checks, we
also consider unadjusted buy-and-hold returns, buy-
and-hold returns adjusted by subtracting the size and
book-to-market matched portfolio returns, as well
as those adjusted by subtracting returns of indus-
try, size, and book-to-market matched portfolios.16
We also include the firm’s industry-adjusted return
on assets, ROA, as an additional measure of prior per-
formance. If stock returns are noisy measures of per-
formance, there may be incremental information in
firms’ accounting performance measures.
4.2.3. Residual CARs (RCARs). The stock mar-
ket’s reaction to the departure news potentially could
contain information about the value of the CEO to
a company. As discussed above, this variable (CAR)
is the dependent variable in one of our tests to be
discussed in §4.3.1. However, to allow for the possi-
bility that the market might have information about
CEO ability that is not already reflected in prior per-
formance and CEO pay, we include the residual from
a regression of CAR on other predeparture variables
(including COMP, BHAR, and ROA), in Equation (1)
in §4.3.1, as an additional explanatory variable in
other tests.
The announcement period return could be noisy,
because other types of announcements may cluster
around the CEO’s departure announcement. Noise in
the announcement period returns that is orthogonal
to the impact of a CEO’s departure on firm value,
per se, is not a problem for our analysis and biases
our tests against finding significant effects. It is a more
serious problem if the information released is corre-
lated with the type of departures in such a way that
it biases our tests in favor of evidence of managerial
ability.
In Table 2, we report, for each type of labor market
progress classification, the percentage of times a given
type of news announcement occurs from one day
before to seven days after the departure announce-
ment. The “good performance” category includes
news items reporting an improvement in firm perfor-
mance, such as a dividend increase or an improve-
ment in earnings, sales or operating performance. The
“poor performance” category includes news reporting
deterioration in firm performance, such as a dividend
cut, a decrease in earnings or sales, or deterioration in
operating performance. The “other good news” cate-
gory comprises news reporting other good news asso-
ciated with the company, such as an upgrade in its
16
We use 10 size groups and 5 book-to-market groups. A number of
studies use prior stock returns as a measure of performance under
the management of a CEO, e.g., Warner et al. (1988) and Fee and
Hadlock (2003).
Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
Management Science 56(10), pp. 1633–1652, © 2010 INFORMS 1641

Table 2 Frequency of Other News Announcements outcomes in the managerial labor market.17 As dis-
cussed below, this biases our tests against finding evi-
Progress
dence consistent with managerial ability.
All Very poor Poor Moderate Good In our regressions, we explicitly control for such
Type of news (Proportion)
announcements by incorporating indicator variables
Good performance (%) 9
66 10
18 3
03 11
43 8
45 corresponding to the different types of the other
Poor performance 8
51 12
39 12
12 3
81 1
41 announcements during the departure announcement
Other good 2
99 3
10 0
00 3
81 2
82 period. Although we do not tabulate the coefficients
Other bad 4
60 5
75 6
06 3
81 1
41 of these indicator variables (except in Table 4), the
Expansion 4
37 3
54 9
09 5
71 2
82
poor performance and the other bad news news indi-
Restructuring 3
45 3
98 3
03 2
86 2
82
Total (number of obs.) 435 226 33 105 71 cators are generally significant in our regressions.

Notes. This table reports the frequency of six other types of new announce-
ments over the same window as that of CAR(−1, +7) around the date of the
announcement of a CEO departure. The good performance category includes
news reports of an improvement in the performance of the firm, such as
an increase in its dividend payment or an improvement in earnings, sales
or operating performance. The poor performance category includes news
reports of deterioration in the performance of the firm, such as a dividend cut,
a decrease in earnings or sales, or deterioration in operating performance.
The other good category includes news reports of other good news con-
cerning the company, such as an upgrade in its credit rating. The other bad
category includes news reports of other bad news concerning the company,
such as a downgrade in its credit rating. The expansion category includes
0 +
1 BHAR +
2 ROA +
3 COMP
articles revealing an expansion in the company’s business, including the for-
4 SIZE +
5 (other news announcement
mation of partnerships and strategic alliances and the winning of new con-
tracts. The restructuring category includes news revealing a restructuring of
the company, including a reduction in the number of company employees
and the sale of plant. The good progress category comprises CEO depar-
tures that meet any of the following three conditions: (i) the CEO ends up as
the CEO of another public company within three years of the departure and
either has a new salary that exceeds his old salary or joins a company that
is larger in size (market value of equity plus book value of debt) than his old
company; (ii) the CEO ends up as a non-CEO executive of another company
within three years of the departure and has a higher salary than in his old
company; or (iii) the CEO joins a private company as a CEO within one year.
The very poor progress category includes those CEOs who have not secured
a new appointment within three years of their departure from their previous
CEO positions. The poor progress category includes those CEOs who have
taken up only new directorships within three years of their departure from
their previous CEO positions. The moderate progress category includes the
remaining departing CEOs who take up a managerial position in another pri-
vate or public company within three years of the departure and meet none of
1 and
2 will be zero.
the three good progress conditions.
credit rating. Similarly, the “other bad news” category
comprises other bad news associated with the com-
1 or
2 is
pany, such as a downgrade in its credit rating. The
“expansion” category reflects news items revealing
an expansion in the company’s business. Finally, the
“restructuring” category includes news items reveal-
ing a restructuring of the company, including a reduc-
tion in the number of company employees and the
sale of company plant. Table 2 indicates a higher inci-
dence of announcements that indicate poor perfor-
mance or convey other types of negative informa-
tion surrounding departures that are associated with
poor labor market progress. Thus, these other types
of announcements make it less likely that we can
find a positive stock price reaction when CEO depar-
tures are due to poor performance, or result in poor
4.3. Hypotheses and Tests
4.3.1. Stock Market Reaction to Departure News.
We first examine whether financial markets relate
value creation to CEOs. To this end, we regress the
abnormal returns around the departure news (CARs)
on the performance measures prior to the CEO depar-
ture (BHAR and ROA) and his prior relative pay
(COMP):
CAR =
+
indicators) + 
(1)
Our first null hypothesis is that the market does
not associate prior performance with CEO ability.
This null hypothesis reflects the view that a firm’s
performance is primarily determined by non-CEO
factors such as its core competencies, product mix,
the innovativeness of other employees, or simply fac-
tors outside the control of the CEO, such as shifts
in demand for its products, prices of its inputs, or
exchange rate movements. If this null hypothesis is
true, the market would not associate prior perfor-
mance with the CEO running the firm, and BHAR or
ROA would not have any effect on the market’s reac-
tion to the departure news, i.e.,
An alternative view is that the market perceives the
ability of the CEO to be an important determinant of
firm performance. The null hypothesis will be rejected
against this alternative hypothesis if either
negative.
Our second null hypothesis is that the market does
not associate higher relative CEO pay with either
higher CEO ability or more skimming by the CEO.
A possible reason for cross-sectional variation in rel-
ative CEO pay that does not rely on differences in
either the ability or “power” of the CEO is that pay
responds to “luck” (i.e., factors outside the control of
the CEO). Another possible reason is that manage-
ment of certain types of organizations requires higher
17
The evidence in Table 3 is consistent with this intuition: the aver-
age announcement effects for poor and very poor progress classifi-
cations are insignificantly different from zero, rather than positive
as might be expected.

1642
compensation for more managerial effort or risk bear-
ing. If this null hypothesis is valid, the coefficient
of COMP,
3 , should be zero. If, on the other hand,
CEO pay reflects CEO ability, then
3 should be neg- CEO who has managed a firm well may want to “quit
ative. Finally, the null hypothesis could be rejected
in favor of the view that variations in relative CEO
pay reflect variations in CEO power across firms.
Bebchuk et al. (2007) argue that the relative pay of
a CEO (“CEO-centrality”) measures how entrenched
the CEO is within the firm. If CEO pay responds
to luck, but responds more to good luck than bad
when CEOs are entrenched, higher relative CEO pay
reflects rent extraction. If this view is true, the depar-
Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
Management Science 56(10), pp. 1633–1652, © 2010 INFORMS
a potential employer and thus have an independent
effect on his labor market progress, it could also affect
the other parameter estimates. For example, an older
while still at the top” and take early retirement or a
less active position in another company. As a result,
we report all our estimates of Equation (2) not only
for the overall sample but also for the subsample for
which AGE is below median.
Our first null hypothesis for this test reflects the
same arguments as that for specification (1). If the
managerial labor market does not associate the prior
performance and the announcement period returns
ture of an overpaid manager may be good news for
the shareholders and the coefficient associated with
COMP may be positive.
4.3.2. Labor Market Outcomes. We next examine
whether the labor market rewards managers for per-
ceived managerial ability. Specifically, we estimate the
following model:
with CEO ability, the coefficients i , i = 1 2 3 will
all be zero. This null hypothesis reflects the view
that firms perform differently due to reasons unre-
lated to CEO ability, such as the uniqueness of prod-
ucts, stakeholder relationships, the innovativeness of
other employees, or exogenous shocks. On the other
hand, if better prior performance and a more nega-
tive market reaction are regarded by the managerial
PROGRESS = 0 + 1 RCAR + 2 BHAR + 3 ROA
labor market as indications of higher managerial abil-
+ 4 COMP + 5 AGE + 6 SIZE ity, then 1 should be negative and i , i = 2 3 should
be positive.
+ 7 (other news announcement
Our second null hypothesis also reflects the same
indicators) + 
(2) arguments as that for specification (1). If the labor
market does not associate higher relative pay for
The dependent variable is the progress rank of the
the CEO with higher CEO ability or more CEO
CEO in the managerial labor market. We first esti-
power, the coefficient 4 in specification (2) should
mate a probit model in which managerial progress is
be zero. However, if CEO ability is recognized both
assigned a dichotomous ranking—1 if the progress is
within the firm and by the managerial labor mar-
“satisfactory” (i.e., either good or moderate progress)
ket, and rewarded by means of higher pay relative to
and 0 otherwise. Subsequently, we estimate an
other executives inside the firm and better labor mar-
ordered logit model in which progress has a rank
from 1 to 4, with 4 corresponding to “good progress”
and 1 corresponding to “very poor progress.” The
four-way classification has the limitation that it
ket progress, respectively, the coefficient 4 should
be positive. Finally, if higher CEO relative pay is
associated with more skimming, the labor market is
assumes a “linear” effect of the independent variables
from one category of progress to another; however, it
has the advantage that it takes account of more infor-
mation. For our results to hold under the four-way
classification, the effects would have to be monotonic
across the different ranks.
Compared to the specification in Equation (1), we
add two more explanatory variables. One is RCAR,
the regression residual from Equation (1). If there
is information content about managerial ability in
the market’s reaction to the departure announcement,
RCAR is likely to capture the other relevant informa-
tion about managerial ability that is not contained in
the prior performance (BHAR) and the CEO’s relative
pay (COMP).18 The other additional variable is CEO
age (AGE). AGE could not only affect the CEO’s util-
ity from another employment or his attractiveness to
18
Note that the coefficient of RCAR in (2) is the same as that of CAR
when all other explanatory variables in (1) are also present in (2).
unlikely to reward CEOs with better positions, and 4
should be negative.
4.3.3. Postdeparture Firm Performance. The tests
discussed above relate to whether or not financial
and labor markets associate higher relative CEO pay
and better prior performance with higher CEO ability.
It is important, however, to examine whether the per-
ceived ability differences are “real.” In other words,
is actual firm performance after the CEO’s departure
consistent with relative pay, prior performance, and
the market’s reaction to departure being systemati-
cally related to CEO ability differences?
To address this question, we examine whether the
change in the industry-adjusted ROA of a firm that
The main advantage of including RCAR is that the coefficients of
COMP and BHAR then reflect their direct effects on the dependent
variable as well as any indirect effect that “works through” CAR.
Because ROA is insignificant in Equation (1), we drop ROA in gen-
erating the residual for subsequent analysis.
Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
Management Science 56(10), pp. 1633–1652, © 2010 INFORMS
loses its CEO is associated with RCAR, BHAR, and
COMP—variables that are potentially correlated with
the market’s perception of CEO ability. Specifically,
we estimate the following model:
CHANGE_ROA
= 0 + 1 RCAR + 2 BHAR + 3 COMP
+ 4 PAST_ROA + 5 SIZE
+ 6 (other news announcement indicators) + 
(3)
PAST_ROA is the industry-adjusted ROA for the year
before the year of the CEO’s departure.
As in the earlier tests, our first null hypothesis cor-
responds to the view that prior performance and the
market’s reaction to the CEO’s departure news are
unrelated to CEO ability. Under this null hypothesis,
the coefficients i , i = 1 2 should be all zero. An alter-
native view is that CEO ability is positively related to
prior performance, and negatively related to RCAR.
Thus, the null hypothesis is rejected against this alter-
native if 1 is positive and/or 2 is negative.
Our second null hypothesis, as in specifications (1)
and (2), concerns the coefficient of COMP. If cross-
sectional variations in COMP are unrelated to CEO
ability or power, the coefficient 3 should be zero.
A second view is that CEO pay reflects CEO ability. If
3 is negative, the null hypothesis is rejected in favor
of this alternative. A third view of CEO relative pay is
that it is associated with CEO entrenchment or power.
If 3 is positive, the null hypothesis is rejected in favor
of this alternative.
4.3.4. Discussion. Our approach to the question
of whether CEO ability matters for firm performance,
and whether pay reflects CEO ability, utilizes three sets
of tests, as discussed above. Each of our three tests
has a particular advantage. For example, tests of the
stock market’s reaction to the departure news utilize
information about the event within a short window.
Although we do find some evidence of other contem-
poraneous news, such announcements are likely to
make it more difficult for the ability hypothesis to be
accepted over the null. The tests related to labor mar-
ket progress have the advantage that the labor mar-
ket is likely to generate and utilize more information
about an executive than is observable to a researcher,
or even to the financial markets when the departure
is announced. To that extent, as long as the progress
classification is reasonably unambiguous, any relation
between prior performance and pay and labor market
outcomes is strong evidence of the ability hypothesis.
Finally, the tests based on financial market’s reaction,
and to a lesser extent those based on labor market out-
comes, rely on market perceptions of ability. The tests
on postdeparture performance do not have this limi-
tation. However, because they are necessarily over a
1643
longer horizon, they are likely to be somewhat affected
by confounding events.
An important additional advantage of our ap-
proach is that collectively, the three sets of tests make
it less likely that alternative explanations could lead
to a false rejection of the null hypotheses. For exam-
ple, it might be argued that CEOs jump ship and
quit voluntarily when they expect future prospects
to deteriorate and are forced to quit when the prior
performance is poor. If this is the case, voluntary
departures could signal reversal of prospects in the
future for better performers, and forced departures
could indicate that governance has strengthened to
force out previously entrenched managers in poorly
performing firms. Although this might explain why
prior performance is negatively related to announce-
ment returns and future operating performance, it
would not explain why manager’s labor market
progress should be positively related to past pay. Such
an explanation requires pay to be low when perfor-
mance is poor prior to the departure, quite the oppo-
site of a governance-change explanation.
5. Results
5.1. Univariate Comparisons
Table 3 reports the CARs based on the market model
for two windows: from day −1 to +1 and from day −1
to +7 of the departure announcement. For the overall
sample, the mean and median CARs are significantly
negative. For the good and moderate progress groups
combined, the mean and median CARs are more neg-
ative. These CARs are also statistically smaller than
those for the poor and very poor progress groups com-
bined (p-value between 0.01 and 0.07). These results
are consistent with the idea that managers that expe-
rience better progress in the managerial labor market
are perceived to be more valuable and the market asso-
ciates their departures with greater loss of firm value.
Departures for the combined poor and very poor
progress group are not associated with statistically
significant CARs. Earlier studies have recognized that
abnormal returns around CEO departure announce-
ments, especially for poorly performing firms or
forced turnovers, can be ambiguous. For example,
Warner et al. (1988, p. 466) suggest that “abnormal
stock return at announcement is the sum of two com-
ponents. One is an information component that is
negative if the change signals worse management per-
formance than anticipated. The second is a real com-
ponent that is positive if the change is in shareholders’
interest. A positive net effect is expected only if the
real component is larger in absolute value than the
information component.”19
19
See also Denis and Denis (1995) for a similar argument.
 Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
1644 Management Science 56(10), pp. 1633–1652, © 2010 INFORMS

Table 3 Departure Announcement Effects Table 4 Stock Market Reaction to Managerial Departures

CAR(−1, +7) in % CAR(−1, +1) in % Intercept 0
007∗ 0
007∗ 0
020∗∗

1
83 1
84 2
54
Median Mean Median Mean
(p-value) (p-value) (p-value) (p-value) Three-year buy-and-hold return −0
010∗∗ −0
010∗∗ −0
010∗∗
−2
64 −2
64 −2
46
CEO departures −1
54 −2
52 −1
12 −1
53
ROA 0
033 0
033 0
020
0
00 0
01 0
01 0
04
0
48 0
48 0
28
Good and moderate −2
59 −4
11 −1
79 −2
70
(satisfactory) progress 0
00 0
00 0
00 0
00 Abnormal_CEO_pay −4.2e−9∗∗
−2
46
Poor and very poor −0
66 −0
80 −0
08 −0
60
(unsatisfactory) progress 0
43 0
58 0
55 0
59 Abnormal_pay_difference −4.2e−9∗∗
CAR for the satisfactory 0
03 0
04 0
01 0
07 −2
49
progress < CAR for the Relative_total_pay −0
036∗∗
unsatisfactory progress −2
77
Notes. This table shows the announcement effects of the CEO departures. Firm’s size −1.5e−7∗∗ −1.4e−7∗∗ −3.5e−8∗
The good progress category comprises CEO departures that meet any of the −2
52 −2
52 −1
91
following three conditions: (i) the CEO ends up as the CEO of another public News indicator good performance 0
007 0
007 0
007
company within three years of the departure and either has a new salary that 0
41 0
41 0
50
exceeds his old salary or joins a company that is larger in size (market value
of equity plus book value of debt) than his old company; (ii) the CEO ends up News indicator other good news 0
028 0
028 0
019
as a non-CEO executive of another company within three years of the depar- 0
60 0
59 0
46
ture and has a higher salary than in his old company; or (iii) the CEO joins News indicator poor performance −0
090∗ −0
090∗ −0
086∗
a private company as a CEO within one year. The very poor progress cate- −1
91 −1
90 −1
81
gory includes those CEOs who have not secured a new appointment within
three years of their departure from their previous CEO positions. The poor News indicator other bad news −0
013 −0
013 −0
023
progress category includes those CEOs who have taken up only new director- −0
29 −0
28 −0
49
ships within three years of their departure from their previous CEO positions. News indicator restructuring −0
126∗ −0
127∗ −0
131∗
The moderate progress category includes the remaining departing CEOs who −2
02 −2
03 −2
13
take up a managerial position in another private or public company within
News indicator business expansion −0
046∗∗ −0
046∗∗ −0
043∗∗
three years of the departure and meet none of the three good progress con-
−2
66 −2
67 −2
54
ditions. CAR(−1, +1) and CAR(−1, +7) are the cumulative abnormal return,
based on the market model, for the windows (−1 day, +1 days) and (−1 day, Number of firm years 298 298 298
+7 days) around the announcement date of the CEO departures. R2 0
127 0
127 0
095

5.2. Regression Results
5.2.1. Main Tests.
5.2.1.1. Stock Market Reaction to Departure News.
In Table 4, we present our results for Equation (1).
Because extreme CARs can be very noisy, we esti-
mate Equation (1) using the weighted least squares
procedure.20 Results are reported for three regressions
using our three different pay measures. The relation
between past performance (BHAR) and the CAR is
significantly negative, which rejects the null hypoth-
esis that managerial ability is inconsequential for
firm performance. This result supports the alternative
hypothesis that the market associates superior stock
performance with higher CEO ability, and reacts more
negatively when a more capable manager who gener-
ated higher stock returns leaves a company.
The pay measures are all negatively related to the
announcement effects. This supports the hypothe-
sis that more capable managers are rewarded with
higher pay and that their departures are associated
with more negative market reaction. Not only is there
no support for the null hypothesis that CEO pay is
20
We thank an anonymous referee for suggesting the weighted least
squares procedure for this regression.
Notes. This table reports the results of the three weighted least square
regressions—the estimated coefficients, their respective t statistics (in
parentheses) based on robust standard errors and by-year clustering, R2 ,
and number of firm years. The dependent variable is the cumulative abnor-
mal return (CAR), based on the market model, for the window (−1 day,
+7 days) around the announcement day of a top managerial departure.
Three-year buy-and-hold return is the buy-and-hold return for the three-
year period before the year of the managerial departure. ROA is measured
over the year before the year of the executive departure. Three-year buy-
and-hold return and ROA are adjusted by subtracting the contemporane-
ous median measure for all non-turnover firms with the same two-digit
SIC code Abnormal_CEO_pay is the three-year predeparture average of
the residual from a regression where the CEO’s total compensation is the
dependent variable, and the explanatory variables include the sum of the
total compensation of the four other highest-paid executives in the same
company, total assets, sales growth, year, and industry indicator variables.
Abnormal_pay_difference is the three-year predeparture average annual
residual from a regression where the difference between the CEO’s total
compensation and the average of the total compensation of the four other
highest-paid executives in the same company is the dependent variable, and
explanatory variables include total assets, sales growth, year, and industry
indicator variables. Relative_total_pay is the ratio of the CEO’s total compen-
sation to the sum of the total compensation of the four other highest-paid
executives in the company over the last three full fiscal years prior to the
CEO’s departure. Firm’s size is the book value of debt plus the market value of
equity of the company at the end of year before the year of the CEO’s depar-
ture. The six indicator variables for different types of news announcements
are described in Table 2.
∗∗∗ ∗∗
, , and ∗ indicate the 1%, 5%, and 10% levels of significance,
respectively.
Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
Management Science 56(10), pp. 1633–1652, © 2010 INFORMS
unrelated to CEO ability, the negative coefficient on
COMP is also inconsistent with the “skimming” view
(Bebchuk and Fried 2004, Bebchuk et al. 2008). How-
ever, we find that the relationship of pay to the stock
market’s reaction to the departure announcement, the
CEO’s labor market progress, and subsequent firm
performance, depends on firm governance. Untabu-
lated tests indicate that relative CEO pay is either
insignificant or marginally significant in specifica-
tion (1), and insignificant in specifications (2) and (3),
for a subsample of departures with poor governance
characteristics, as measured by the G-Index. However,
our results remain for the complementary subsample
of firms with good governance characteristics.
The effects of the variables of interest in Equa-
tion (1) are economically significant. A one-standard-
deviation increase in BHAR leads to a 1.4% decrease
in CAR (from one day before to seven days after the
departure announcement). A one-standard-deviation
increase in our relative pay measure COMP leads to
a 2.7% decrease in CAR.
As robustness checks, we redo all the tests by
changing the dependent variable to CAR−1 +1,
FFCAR−1 +1, and FFCAR−1 +7, respectively.
The (untabulated) results are similar. The results also
hold when we adjust the buy-and-hold return by
subtracting the corresponding return of the industry,
size, and book-to-market-matched portfolio. The coef-
ficient associated with the industry-adjusted buy-and-
hold return is virtually identical when we separately
include the industrial buy-and-hold return. This sug-
gests that financial markets mainly “credit” the man-
agers for industry-adjusted performance. Inclusion of
CEO death events does not affect our conclusions
(untabulated results).
Turning to other explanatory variables, firm size
has a negative significant effect in all regressions.
Most of the other control variables are insignificant,
with the exception of POORperf (our proxy for the dis-
closure of news items concerning poor performance),
which is, unsurprisingly, negative and significant.
ROA is generally insignificant. After controlling for
stock performance, ROA appears to have no incre-
mental information about managerial ability. This
may reflect the fact that past stock returns may have
already incorporated the relevant information con-
tained in the past accounting performance.
5.2.1.2. Labor Market Outcomes. In Tables 5 and 6,
we report regression results corresponding to Equa-
tion (2). Table 5 reports the marginal effects for a
one-standard-deviation increase in the explanatory
variable on the probability of satisfactory labor mar-
ket progress from the probit model, whereas Table 6
reports the coefficient estimates from the ordered logit
regression based on our four-way classification. Both
models reject the null hypothesis that CEO ability is
1645
inconsequential for firm value and support the man-
agerial ability hypothesis. RCAR has a negative coef-
ficient in all specifications that is significant at least
at the 5% level. BHAR has a positive significant coef-
ficient in all regressions (significant at the 5% level
in the probit model in four out of six regressions).
Although the simple relative pay measure has the
right sign, it is not significant at conventional levels.
However, the two other relative pay measures that
are based on regression residuals are significant at the
5% level in the ordered logit regression for the overall
sample and the 10% level in the other regressions.
The incremental effects of the dependent vari-
ables in Table 5 are economically significant. A one-
standard-deviation decrease in the RCAR increases
the probability of a successful labor market outcome
by about 6% for the overall sample and about 12%
for the young CEO group. A one-standard-deviation
increase in the relative pay increases the probability
by 7% to 8% when CEO excess relative pay is cal-
culated based on the regression residuals, although
the magnitudes for the simple measure of relative
pay are smaller. A one-standard-deviation increase in
BHAR increases the probability of successful labor
market progress by 10% for the overall sample but
by as much as 15% for the sample of young CEOs.
Table 5 shows that the sensitivity of CEOs’ labor mar-
ket progress to RCAR and BHAR is stronger for the
sample of young CEOs than for the overall sample.
Consistent with Table 4, firm size continues to have
a significant positive effect on labor market progress
in most specifications. Interestingly, the ordered logit
model in Table 6, for which our progress classification
incorporates information on the size of the new firm
and salary of the new position, shows that the size
effect is stronger, both economically and statistically,
for younger CEOs.
We replicate our results by calculating cumula-
tive abnormal returns using the market model over
the period from a day before to a day after the
departure announcement. The results remain unaf-
fected. Adding the Fama-French factors to calculate
abnormal returns (i.e., FFCARs instead of CARs) pro-
duces very similar results over both windows.21 These
results are not tabulated. We also check the robustness
of our results by adjusting buy-and-hold returns with
respect to industry, size, and book-to-market portfo-
lio returns.22 The results are qualitatively unchanged.
To ensure that our results on relative pay and RCAR
are not due to potential nonlinearities in the relation-
ship between BHAR and career progress, we replicate
21
In fact, the coefficients for both measures of residual pay become
more significant (at 5%) when we use FFCARs or the (−1, +1) win-
dow when we use the two-way classification.
22
For this BHAR measure, relative total pay becomes more signifi-
cant (at 10%) for the two-way progress classification.
 Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
1646 Management Science 56(10), pp. 1633–1652, © 2010 INFORMS

Table 5 CEO Career Progress (Incremental Effects)

Overall sample Young CEO sample

∗∗∗ ∗∗∗ ∗∗∗ ∗∗
Residual CAR−1 +7 −0
059 −0
060 −0
051 −0
117 −0
117∗∗ −0
122∗∗
−2
65 −2
67 −2
69 −2
34 −2
34 −2
48
Three-year buy-and-hold return 0
103∗∗ 0
102∗∗ 0
102∗ 0
147∗∗ 0
148∗∗ 0
134∗
1
92 1
95 1
82 2
03 2
03 1
82
ROA −0
034 −0
035 0
036 0
003 0
003 0
007
−1
23 −1
27 −1
21 0
06 0
06 0
17
Abnormal_CEO_pay 0
077∗ 0
069∗
1
86 1
88
Abnormal_pay_difference 0
086∗ 0
069∗
1
94 1
88
Relative_total_pay 0
038# 0
012
1
36 0
41
CEO age −0
091∗∗∗ −0
087∗∗∗ −0
092∗∗∗ −0
107∗∗∗ −0
107∗∗∗ −0
117∗∗∗
−3
83 −3
66 −4
07 −3
91 −3
92 −4
18
Firm’s size 0
083∗∗∗ 0
084∗∗∗ 0
059# 0
041 0
041 0
061∗
2
98 3
16 1
51 1
08 1
07 1
69
Number of firm years 298 298 298 167 167 167
Pseudo R2 0.101 0.098 0.088 0.137 0.137 0.135

Notes. This table reports the results of the two probit regressions: the marginal effect corresponding to an increase in the predicting
variable by one standard deviation, their respective z statistics (in parentheses) based on robust standard errors and by-year clustering,
pseudo R2 , and number of firm years. Young CEO sample consists of those cases in which the age of the departing CEO is at or below
the median age. The dependent variable is progress that takes a value of 1 if the departing CEO obtains a new managerial position
within three years of his departure, and 0 otherwise. Residual CAR−1 +7 is the residual cumulative abnormal return, based on the
market model, for the window (−1 day, +7 days) around the announcement day of the CEO departures from the regression in Table 4.
Three-year buy-and-hold return is the buy-and-hold return for the three-year period before the year of the managerial departure. ROA is
measured over the year before the year of the executive departure. Three-year buy-and-hold return andROA are adjusted by subtracting
the contemporaneous median measure for all nonturnover firms with the same two-digit SIC code. Abnormal_CEO_pay is the three-
year predeparture average of the residual from a regression where the CEO’s total compensation is the dependent variable, and the
explanatory variables include the sum of the total compensation of the four other highest-paid executives in the same company, total
assets, sales growth, year, and industry indicator variables. Abnormal_pay_difference is the three-year pre-CEO-departure average
residual from a regression where the difference between the CEO’s total compensation and the average total compensation of the four
other highest-paid executives in the same company is the dependent variable, and the explanatory variables include total assets, sales
growth, year, and industry indicator variables. Relative_total_pay is the ratio of the CEO’s total compensation to the sum of the total
compensation of the four other highest-paid executives in the company over the last three full fiscal years prior to the CEO’s departure.
CEO age is the age of the departing CEO. Firm’s size is the book value of debt plus the market value of equity of the company at the end
of year before the year of the CEO’s departure. The regressions include six indicator variables for other types of news announcements
(described in Table 2) over the same window as that of CAR−1 +7, but their coefficients are not reported here for brevity.
∗∗∗ ∗∗
, , and ∗ indicate the 1%, 5%, and 10% levels of significance, respectively; # indicates significance at the 10% level by a
one-sided test.

our results in Tables 5 and 6 by incorporating higher
order terms of BHAR. The results (which are not tab-
ulated) are mainly unchanged. Our results in Table 6
are also robust to alternative definitions of good and
moderate progress, and to using CEO age of 58 and
55 as alternative cutoffs instead of age 61.
5.2.1.3. Postdeparture Firm Performance. Table 7
reports results corresponding to Equation (3). Our
results are consistent with the notion that departures
of more capable CEOs are associated with worse sub-
sequent operating performance. We present results
for both the overall sample and the sample of sat-
isfactory labor market progress (good and moderate
progress). The latter sample is useful to study sepa-
rately because prior studies have mostly documented
performance improvements around involuntary CEO
changes. Table 7 shows that RCAR is positively
related to the performance change for both samples,
and the effect is significant at the 1% level in the first
year. BHAR is negatively related to the performance
change, and the effect is significant at the 10% level
in the third year for the overall sample, and at the 1%
level in the first year and 5% level in the third year for
the sample of satisfactory progress. CEO pay relative
to the pay of other top executives, as measured by
abnormal_CEO_pay, has a negative effect, significant at
the 5% level in the first year for the overall sample
and the 10% level in the third year for the sample of
satisfactory progress. Results for the other two mea-
sures of COMP are similar but are not reported in
the table. Untabulated tests indicate that our results
remain whether or not we include a sample of CEO
death events in the analysis. The results are econom-
ically significant. A one-standard-deviation change in
Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
Management Science 56(10), pp. 1633–1652, © 2010 INFORMS 1647

Table 6 CEO Career Progress with a Finer Progress Classification (Ordered Logit)

Overall sample Young CEO sample

∗∗ ∗∗ ∗∗ ∗∗
Residual CAR−1 +7 −1
441 −1
441 −1
220 −2
650 −2
652∗∗ −2
725∗∗∗
−2
20 −2
20 −2
56 −2
58 −2
58 −2
62
Three-year buy-and-hold return 0
162∗ 0
162∗ 0
163∗ 0
169∗ 0
169∗ 0
158#
1
73 1
73 1
65 1
65 1
65 1
56
ROA −0
800 −0
802 −0
758 0
343 0
343 0
421
−0
89 −0
89 −0
78 0
27 0
27 0
33
Abnormal_CEO_pay 4
7e−8∗∗ 5
1e−8∗
2
07 1
79
Abnormal_pay_difference 4
8e−8∗∗ 5
1e−8∗
2
06 1
80
Relative_total_pay 0
302 0
273
0
74 0
48
CEO age −0
076∗∗∗ −0
076∗∗∗ −0
078∗∗∗ −0
096∗∗∗ −0
096∗∗∗ −0
102∗∗∗
−4
66 −4
65 −4
91 −3
93 −3
93 −4
97
Firm’s size 2
9e−6∗∗∗ 2
8e−6∗∗∗ 1
4e−6∗∗∗ 4
1e−6∗∗∗ 4
1e−6∗∗∗ 5
7e−6∗∗∗
2
87 2
89 3
07 3
31 3
29 5
37
Number of firm years 298 298 298 167 167 167
Pseudo R2 0.056 0.056 0.053 0.071 0.071 0.070

Notes. This table reports the results of the two ordered logistic regressions: the estimated coefficients, their respective z statistics (in parentheses) based
on robust standard errors and by-year clustering, pseudo R2 , and number of firm years. Young CEO sample consists of those cases in which the age of the
departing CEO is at or below the median age. The dependent variable is progress. The good progress category (progress = 4) comprises CEO departures that
meet any of the following three conditions: (i) the CEO ends up as the CEO of another public company within three years of the departure and either has a new
salary that exceeds his old salary or joins a company that is larger in size (market value of equity plus book value of debt) than his old company; (ii) the CEO
ends up as a non-CEO executive of another company within three years of the departure and has a higher salary than in his old company; or (iii) the CEO joins
a private company as a CEO within one year. The very poor progress category (progress = 1) includes those CEOs who have not secured a new appointment
within three years of their departure from their previous CEO positions. The poor progress category (progress = 2) includes those CEOs who have taken up
only new directorships within three years of their departure from their previous CEO positions. The moderate progress category (progress = 3) includes the
remaining departing CEOs who take up a managerial position in another private or public company within three years of the departure and meet none of the
three good progress conditions. Residual CAR−1 +7 is the residual cumulative abnormal return, based on the market model, for the window (−1 day,
+7 days) around the announcement day of the CEO departures from the regression in Table 4. Three-year buy-and-hold return is the buy-and-hold return
for the three-year period before the year of the managerial departure. ROA is measured over the year before the year of the executive departure. Three-year
buy-and-hold return and ROA are adjusted by subtracting the contemporaneous median measure for all nonturnover firms with the same two-digit SIC code.
Abnormal_CEO_pay is the three-year predeparture average of the residual from a regression where the CEO’s total compensation is the dependent variable, and
the explanatory variables include the sum of the total compensation of the four other highest-paid executives in the same company, total assets, sales growth,
year, and industry indicator variables. Abnormal_pay_difference is the three-year pre-CEO-departure average residual from a regression where the difference
between the CEO’s total compensation and the average total compensation of the four other highest-paid executives in the same company is the dependent
variable, and the explanatory variables include total assets, sales growth, year, and industry indicator variables. Relative_total_pay is the ratio of the CEO’s total
compensation to the sum of the total compensation of the four other highest-paid executives in the company over the last three full fiscal years prior to the
CEO’s departure. CEO age is the age of the departing CEO. Firm’s size is the book value of debt plus the market value of equity of the company at the end of
year before the year of the CEO’s departure. The regressions include six indicator variables for other types of news announcements (described in Table 2) over
the same window as that of CAR−1 +7, but their coefficients are not reported here for brevity.
∗∗∗ ∗∗
, , and ∗ indicate the 1%, 5%, and 10% levels of significance, respectively; # indicates significance at the 10% level by a one-sided test.

BHARs, COMP, and RCARs is associated with an abso-
lute change in the industry-adjusted return on assets,
from one year before to one year after the departure,
by 0.5%, 0.6%, and 0.8%, respectively. Given that the
mean and median industry-adjusted return on assets
one year prior to the year of the departure are 2% and
0.6%, respectively, these magnitudes are substantial.
5.2.2. Additional Tests
5.2.2.1. Postdeparture Stock Returns. Although Ta-
ble 4 shows that the stock market reacts in a direction
consistent with the effect on firm profitability (as evi-
denced in Table 7) to the news of the CEO’s depar-
ture, it is possible that it still underreacts. For exam-
ple, Warner et al. (1988, p. 482) find a delayed reaction
after the departure of the CEO and conclude “the pos-
sibility of a profitable trading rule (ignoring transac-
tions costs) from going short at announcement cannot
be dismissed.” If indeed the financial markets under-
react to the news of the CEO’s departure, we could
expect the stock price performance over the next one
to three years to be also related to RCAR, BHAR, and
COMP in the same way that the change in operat-
ing performance is. However, we caveat that empir-
ical analysis based on long-term stock performance
is challenging for econometric (e.g., dealing with the
lack of independence between observations) and eco-
nomic reasons (e.g., identifying the right performance
benchmark).
 Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
1648 Management Science 56(10), pp. 1633–1652, © 2010 INFORMS

Table 7 Postdeparture Change in ROA of the Old Employers over the same period.23 We report results from a boot-
strap procedure in which we resample with replace-
Good and moderate
Overall sample progress sample ment 50,000 times with by-year clustering.
The results in Table 8 are generally consistent with
Dependent variable: ROA1 ROA3 ROA1 ROA3 our hypothesis that RCAR, BHAR, and COMP are
Residual CAR−1 +7 0
060 ∗∗∗
0
044 #
0
125 ∗∗∗
0
043# associated with CEO ability differences. RCAR has a
3
56 1
58 4
27 1
46 positive coefficient that is statistically significant at
Three-year buy-and-hold −0
003 −0
005∗ −0
006∗∗∗ −0
005∗∗ the 1% level for the overall sample and from the
return −0
98 −1
86 −5
49 −2
06 1% to 10% level for the good and moderate progress
Abnormal_CEO_pay −8.0e−10∗∗ −7.3e−11 −9.5e−10# −4.7e−10∗ group. BHAR has a significant negative effect on stock
−2
42 −0
21 −1
64 −1
81
returns over the two- and three-year horizon. How-
Past ROA −0
246∗∗∗ −0
107∗ −0
289∗∗∗ −0
091∗∗
−6
78 −2
13 −4
14 −2
15
ever, it has a positive significant coefficient on returns
Firm’s size −3.8e−8∗∗ 6.1e−9 −6.0e−8∗∗ −2.9e−8 in the first year after the departure for both sam-
−2
57 −0
33 −2
43 −1
50 ples. This could be due to market underreaction or
Number of firm years 269 190 126 89 delayed reaction to good news associated with firms
R2 0
322 0
199 0
456 0
341 that have good prior performance, similar to that
Notes. This table reports the results of the four regressions: the estimated
found in the momentum literature (see Jegadeesh and
coefficients, their respective t statistics (in parentheses) based on robust Titman 1993). However, after the first year, the effect
standard errors and by-year clustering, R2 , and number of firm years. The of BHAR becomes negative. Finally, relative pay has a
dependent variable is the annualized change in industry-adjusted ROA from negative sign and is significant at the 5% level or less
the year before to the first or the third year after the year of the managerial in three of the six regressions.
departure (ROA1 or ROA3). ROA is adjusted by subtracting the contem-
poraneous median measure for all non-CEO-turnover firms with the same
5.2.2.2. Appointment News CARs and Postappoint-
two-digit SIC code. Good and moderate progress sample consists of those ment Operating Performance. The sample of departures
cases in which the departing CEO obtains a new managerial position within that results in new managerial appointments in pub-
three years of his CEO departure. Residual CAR−1 +7 is the residual licly traded firms provides us with a small subsam-
cumulative abnormal return, based on the market model, for the window ple on which we can implement some additional tests.
(−1 day, +7 days) around the announcement day of the CEO departures
from the regression in Table 4. Three-year buy-and-hold return is the buy-
This sample is even smaller than the good and mod-
and-hold return for the three-year period before the year of the managerial erate progress subsample in Table 7 because many of
departure. Past ROA is measured over the year before the year of the exec- the departures in the latter sample do not result in
utive departure. Three-year buy-and-hold return and Past ROA are adjusted new appointments in publicly traded firms. If the abil-
by subtracting the contemporaneous median measure for all nonturnover ity hypothesis is valid, a higher ability CEO should be
firms with the same two-digit SIC code. Abnormal_CEO_pay is the three-
year predeparture average of the residual from a regression where the CEO’s
associated with a more negative departure CAR at the
total compensation is the dependent variable, and the explanatory variables old firm and a more positive appointment CAR at the
include the sum of the total compensation of the four other highest-paid new firm. Thus, we first examine the correlation of
executives in the same company, total assets, sales growth, year, and indus- the departure and appointment CARs. Consistent with
try indicator variables. Firm’s size is the book value of debt plus the market Hayes and Schaefer (1999), panel A of Table 9 con-
value of equity of the company at the end of year before the year of the CEO’s
departure. The regressions include six indicator variables for other types of
firms that this is the case. Four sets of correlations are
news announcements (described in Table 2) over the same window as that reported, corresponding to the (−1 +1) and (−1 +7)
of CAR−1 +7, but their coefficients are not reported here for brevity. announcement windows. All four correlations are neg-
∗∗∗ ∗∗
, , and ∗ indicate the 1%, 5%, and 10% levels of significance, respec- ative, and three out of the four are significant at a 10%
tively; # indicates significance at the 10% level by a one-sided test. level or less. These results are inconsistent with the
jump ship explanation discussed at the end of §4.
Table 8 reports the results of the following regres-
Next, in specifications similar to Equations (1)
sion:
and (3), we examine whether the appointment CAR
and operating performance of the new firm that the
BHR+1 +T  = 0 + 1 RCAR + 2 BHAR + 3 COMP
CEO joins are related to the CEO’s relative pay in the
+ 4 BENCH_BHR+1 +T  + 5 SIZE previous company, the prior performance of that firm
+ 6 (other news announcement
23
The buy-and-hold return of the benchmark portfolio is con-
indicators) + 
(4) structed as follows. One trading day before the event day, we group
all stocks into three groups based on market capitalization (size)
The dependent variable is buy-and-hold stock returns and the market-to-book of equity within each two-digit SIC indus-
of the company losing the CEO from one week to try (so in each two-digit SIC industry, we have nine groups). We
then identify the group to which the event firm belongs, and we
T weeks after the departure, where T = 53, 105, or 157. use the remaining nonevent firms in the same group to form the
The new explanatory variable BENCH_BHR+1 +T  is benchmark portfolio. We skip one week and then compute the one-,
the buy-and-hold return on a benchmark portfolio two-, or three-year buy-and-hold return for that portfolio.
Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
Management Science 56(10), pp. 1633–1652, © 2010 INFORMS 1649

Table 8 Postdeparture Stock Return of the Old Employers

Overall sample Good and moderate progress sample

One-year Two-year Three-year One-year Two-year Three-year

Dependent variable: return return return return return return

Residual CAR−1 +7 1
937∗∗∗ 1
787∗∗∗ 1
502∗∗∗ 1
872∗∗∗ 1
122∗∗ 1
593∗

5
94 3
74 3
39 4
09 2
29 1
91
Three-year buy-and-hold return 0
163∗ −0
134∗∗∗ −0
145∗∗∗ 0
396∗∗ −0
070∗ −0
135∗
1
66 −3
34 −2
75 2
42 −1
80 −1
79
Abnormal_CEO_pay −1.3e−8# −4.9e−8∗∗∗ −3.5e−8∗∗ −1.4e−8 −4.9e−8∗∗∗ −5.1e−8#
−1
56 −3
41 −2
08 −0
61 −3
01 −1
41
Benchmark portfolio return 0
859∗∗∗ 0
399∗∗∗ 0
271∗ 0
390 0
010 0
0263
4
48 2
78 1
82 1
16 0
05 0
94
Firm’s size −8.6e−7 −1.8e−6∗∗ −1.5e−6# −1.3e−6 −2.2e−6 −2.4e−6
−1
23 −2
05 −1
54 −0
44 −1
00 −0
73
Number of firm years 264 222 155 100 98 89

Notes. This table reports the results—the estimated coefficients and their respective z statistics (in parentheses)—of 50,000-repeat bootstrap regressions
based on resampling with replacement and by-year clustering from the actual sample. The dependent variable is the one-, two-, or three-year (skipping the
immediate week) buy-and-hold stock return of the firm losing the CEO after the managerial departure. Residual CAR−1 +7 is the residual cumulative
abnormal return, based on the market model, for the window (−1 day, +7 days) around the announcement day of the CEO departures from the regression
in Table 4. Three-year buy-and-hold return is the industry-adjusted buy-and-hold return for the three-year period before the year of the managerial departure.
Abnormal_CEO_pay is the three-year predeparture average of the residual from a regression where the CEO’s total compensation is the dependent variable, and
the explanatory variables include the sum of the total compensation of the four other highest-paid executives in the same company, total assets, sales growth,
year, and industry indicator variables. Benchmark portfolio return is computed as follows. One trading day before the event day, we group all stocks into three
groups independently by market capitalization (size) and market-to-book of equity within each two-digit SIC industry. So in each two-digit SIC industry, we
have nine groups. We then identify the group to which the event firm belongs, and use the remaining nonevent firms in the same group to form a portfolio.
We skip one week, and then compute the one-, two-, or three-year buy-and-hold return for that portfolio. Firm’s size is the book value of debt plus the market
value of equity of the company at the end of year before the year of the CEO’s departure. The regressions include six indicator variables for other types of news
announcements (described in Table 2) over the same window as that of CAR−1 +7, but their coefficients are not reported here for brevity.
∗∗∗ ∗∗
, , and ∗ indicate the 1%, 5%, and 10% levels of significance, respectively; # indicates significance at the 10% level by a one-sided test.

under the CEO’s management, and the stock mar-
ket’s reaction to the departure news. For the tests,
we include the explanatory variables of interest one
at a time, because we have severe sample size attri-
tion due to the cumulative effects of missing obser-
vations from all explanatory variables when these are
all included. In the first three columns in panel B of
Table 9, the dependent variable is the appointment
CAR over the (−1, +1) window.24 Consistent with
panel A in Table 9, there is a significant negative
association of the departure CAR over the (−1, +7)
window and the appointment CAR. The results for
relative pay are inconsistent with the “rent extraction”
hypothesis. Although relative pay does not have any
significant association at conventional levels, the sign
of the coefficient is consistent with the ability hypoth-
esis. The economic magnitude is comparable to that
for the same variable in Table 4.25 Prior performance
has a significant positive association, consistent with
the ability hypothesis.
In the last three columns of panel B of Table 9,
the dependent variable is the annualized average
24
We focus on the (−1, +1) window because the correlations in panel
A of Table 9 suggest that the signal-to-noise ratio in the market reac-
tion to appointment news may be the highest over this window.
25
We need to be cautious in making this comparison, because the
specification reported in Table 4 includes BHAR.
change in industry-adjusted ROA (ROA) from one
year before to three years after the appointment.
If the annualized change cannot be calculated over
the three-year period because of data unavailability,
we use data for the first two years, and if that is
also not available, we only use data for the year after
the appointment. Industry adjustment is done by sub-
tracting the contemporaneous median ROA for all
nonturnover firms with the same two-digit SIC code.
A more negative departure CAR is significantly asso-
ciated with greater operating performance improve-
ment in the new firm. Higher CEO relative pay at
the old firm has a significant positive association with
performance improvement in the new firm. Although
better prior performance is also associated with per-
formance improvement, the effect is not statistically
significant at conventional levels. Note, however, that
the economic magnitude of the effect is much larger
than those reported in Table 7 on the change in oper-
ating performance of the old firm.
Overall, these results support the ability hypothesis
and, in addition, further rule out the possibility that
our main results could be due to alternative explana-
tions unrelated to CEO ability, such as the jump ship
explanation discussed in §4.
 Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
1650 Management Science 56(10), pp. 1633–1652, © 2010 INFORMS

Table 9 Cumulative Abnormal Returns Around Departures and Appointments and Firm Performance of the New Employers

Panel A: Correlation between departure CAR and appointment CAR

Appointment CAR

CAR−1 +1 CAR−1 +7

Departure CAR−1 +1 −0
369∗∗∗ −0
188∗

0
0005 0
0874
Departure CAR−1 +7 −0
221∗∗ −0
048
0
042 0
6679

Panel B: Appointment CAR and postappointment change in ROA of the new firm

Appointment Appointment Appointment

Dependent variable: CAR−1 +1 CAR−1 +1 CAR−1 +1 ROA ROA ROA
∗ ∗∗
Departure CAR−1 +7 −0
143 −0
062
1
79 −2
14
Appointment CAR−1 +1 0
039
0
37
Three-year buy-and-hold return 0
032∗∗∗ 0
048
3
81 1
27
Abnormal_CEO_pay 3.8e−9 2.8e−9∗∗
1
10 2
02
Past ROA −0
333∗ −0316∗ −0
270
−1
77 −1
86 −1
65
Firm’s size −3.2e−7∗∗∗ −1.5e−7 −3.4e−7∗∗ 2.5e−7∗ 3.1e−7# 1.1e−7
−3
39 −0
99 −2
57 1
67 1
32 1
07
R-squared 0
11 0
14 0
03 0
50 0
52 0
43
Number of firm years 75 57 71 59 56 67

Notes. Panel A reports the correlation coefficients between the departure CARs and the appointment CARs and the corresponding p-values (in parentheses).
The departure CAR−1 +1 and CAR−1 +7 are the cumulative abnormal return, based on the market model, for the windows (−1 day, +1 days) and
(−1 day, +7 days) around the announcement of the CEO departures. The appointment CAR−1 +1 and CAR−1 +7 are the cumulative abnormal return,
based on the market model, for the windows (−1 day, +1 days) and (−1 day, +7 days) around the announcement of the new appointment of the departing
CEO. Panel B reports results of six regressions: the estimated coefficients, their respective t statistics (in parentheses) based on robust standard errors and
by-year clustering, R2 , and number of firm years. The dependent variable is the appointment CAR−1 +1 for the first three regressions and the annualized
change in industry-adjusted ROA from the year before to the first, second, or third year after the managerial appointment (ROA) for the next three regressions.
Industry adjustment is done by subtracting the contemporaneous median ROA for all nonturnover firms with the same two-digit SIC code. Three-year buy-
and-hold return is the buy-and-hold return of the old employer for the three-year period before the year of the managerial departure. Past ROA is the ROA of
the new employer over the fiscal year before the new executive appointment. Three-year buy-and-hold return and Past ROA are adjusted by subtracting the
contemporaneous median measure for all nonturnover firms with the same two-digit SIC code. Abnormal_CEO_pay is the three-year predeparture average
of the residual from a regression where the CEO’s total compensation is the dependent variable, and the explanatory variables include the sum of the total
compensation of the four other highest-paid executives in the same company, total assets, sales growth, year, and industry indicator variables. Firm’s size is
the book value of debt plus the market value of equity of the new company at the end of year before the year of the appointment.
∗∗∗ ∗∗
, , and ∗ indicate 1%, 5%, and 10% levels of significance, respectively; # indicates significance at the 10% level by a one-sided test.

5.2.2.3. Additional Untabulated Robustness Checks.26
In our main sample, we include cases in which the
incoming CEO is previously the CEO of a non-
ExecuComp company. Therefore, our sample may
have a higher proportion of “good performance”
departures specifically from smaller firms relative to
the population of CEO departures in small firms. This
may introduce a negative correlation between firm
size and performance in the labor market. To mit-
igate this issue, we control for firm size in all our
regressions. As a further robustness test, we exclude
26
We thank an anonymous referee for suggesting these checks.
nine cases in which departing CEOs are from non-
ExecuComp firms. The results from our main regres-
sion analyses stand.
Bebchuk et al. (2008) find lower relative pay for
CEO founders and higher relative pay for CEOs with
longer tenure. Therefore, our results regarding rela-
tive pay may depend on whether the founder status
and tenure are taken into consideration. As a robust-
ness check, we control for the founder status and
tenure and repeat all our major analyses. None of our
conclusions is affected.
The stock market reacts to the CEO departure
announcement based on the expected difference in
ability between the departing and the incoming CEO.
Therefore, the announcement of a specific replacement
Chang, Dasgupta, and Hilary: CEO Ability, Pay, and Firm Performance
Management Science 56(10), pp. 1633–1652, © 2010 INFORMS
for the CEO may make a difference, particularly for
the analyses of the departure announcement effects
and the post departure operating performance of
firms. We control for whether or not the replacement is
announced when the CEO departure is announced by
means of an indicator variable and rerun the regres-
sions. Our results are qualitatively similar.
6. Conclusion
The role of the CEO in the firm is a controversial topic
that has become even more contentious in the context
of the recent financial crisis, where top management
pay has been at the center of academic and policy
debates. Despite its extreme importance, there is sur-
prisingly little direct evidence whether CEOs (or more
generally, top executives) contribute positively to firm
value. In this paper, we test the proposition that CEO
ability matters. In addition, if ability difference exists
across CEOs, we examine whether these differences
are reflected in CEO pay. To do so, we study a sample
of CEO departures and examine how the past per-
formance of the firm under the CEO’s management
and the pay of the CEO relative to that of the other
highest-paid executives of the company are related
to (i) the stock market’s reaction to the departure
news, (ii) the subsequent success of the departing
CEO in the managerial labor market, and (iii) the per-
formance of the firm after the CEO leaves. Our results
are consistent with the view that cross-sectional dif-
ferences in firm value and performance are related to
ability differences across CEOs. We also find evidence
against the dominance of the “rent extraction” view
within our sample of CEO departures.
Acknowledgments
The authors are especially grateful to Alex Edmans and
Rik Sen for detailed suggestions that significantly improved
the paper. The authors also thank Rajesh Aggarwal, Radha
Gopalan, Michael Hertzel, Michael Lemmon, Clive Lennox,
David Matsa, the two referees, David Yermack, Wei Xiong
(the department editor), and seminar participants at the
Summer Research Conference in Finance of the Indian
School of Business (2007) and the Asian Finance Associ-
ation meetings in Yokohama (2008) for helpful comments
and discussions. All errors are the authors’ responsibility.
Gilles Hilary’s current affiliation is Department of Account-
ing, INSEAD, 77000 Fontainebleau, France.
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