Analysts Forecasts: The Secret Sauce Stirring Up CEOs’ Abnormal Pay

Abstract

Jensen and Meckling (1976) claim that by facilitating firms’ activity monitoring, security analysis by financial analysts can reduce agency costs between management and external capital providers, and thereby increase shareholder value. Additionally, boards are required to design executive pay structures to minimise agency problems and related costs. Among the limited studies that explore the relationship between analysts’ forecasts and CEOs’ compensation, one strand reports a positive relation supporting the agency theory, while the other reports a negative relation contradicting the agency theory. This disagreement may stem from the unobserved determinants of CEOs’ compensation structures. Thus, we use CEOs’ abnormal compensation (ACOMP, the proportion of pay that economic determinants cannot accurately determine) to reinvestigate this relation and find conclusive evidence of its negative association with analysts’ forecast metrics. Although consistent with agency theory, this negative relationship is mainly witnessed in firms subject to stronger external monitoring, as indicated by higher corporate governance scores, takeover vulnerability, institutional ownership, and firm-level political risk. Our findings suggest that analysts serve as a proxy for unobserved factors influencing ACOMP and play a key role in aligning CEO interests with those of shareholders.