This study reconciles conflicting recent evidence on the relation between CEO-worker pay ratio and firm value. Consistent with the evidence in Pan et al. (2022), first-time high pay ratio disclosures of U.S. public companies generate negative announcement returns, but returns exhibit a reversal within three months and become positive, especially among firms with high inequality averse institutional shareholders. High pay ratio firms also have stronger operating performance, consistent with the view that high pay ratios reflect managerial talent (Mueller et al., 2017). The market learns about the positive pay ratio-talent relation after three disclosures and subsequently reacts positively to high pay ratio announcements. While sell-side analysts issue more pessimistic
and inaccurate forecasts for these firms, generating stronger earnings surprises, institutional investors progressively overweight high pay-ratio firms, where local investors exhibit quicker weight adjustments. A trading strategy that exploits market’s underreaction to pay ratio disclosures generates an annualized alpha of over 8%.
