Why Top CEOs Earn Big Paychecks

From Alex Tabarrok.

"CEO compensation at large firms is high, especially in comparison to average worker wages, sparking debates over income inequality. Critics argue that such pay packages are unfair and disproportionate to actual company performance. Proponents contend that high pay reflects productivity and is necessary to attract scarce top talent to large firms. Let’s go to the ticker tape.

On August 12 shares of Starbucks were selling for about $77, a level they had been stable at for some time. On August 13, shares were selling for $94. What changed? On August 13, Starbucks announced that they were hiring a new CEO, Brian Niccol, who had held the top position at Chipotle.

There are some 1,132,800,000 Starbucks share outstanding so hiring Niccol instantly increased the value of Starbucks by just over $19 billion. In comparison, Niccol will be paid $1.6 million in salary, a bonus payment of $10 million and potential equity incentives that could be worth on the order of $100 million  or more if the stock continues to do well.

No question, Niccol is paid handsomely but it’s only a small percentage of the billions the market estimates he will create for other people, both consumers and investors.

Niccol has had a phenomenal streak as CEO of Chipotle raising the stock price from about $6 to $56. Thus, it wasn’t surprising that on the announcement of his move, Chipotle stock plunged from $56 to $46 (later recovering to around $52).

Using the latter number, the value of Chipotle fell by about $5.5 billion on the day of the Niccol announcement. That’s a remarkable fall given that the number two at Chipotle is probably no slouch. But heh, Kevin Durant doesn’t make quite as much as Steph Curry. (See yesterday’s post on the benefits of inequality!) Last year, Chipotle paid Niccol a total compensation package worth about $22.5 million. Again, a nice pay package but is there any question that Chipotle investors are sorry to see Niccol go?

Note also that the market expects Niccol to raise the value of Starbucks going forward more than he would have raised the value of Chipotle going forward so this move was a net gain for society. It’s important to remember that CEO pay is not just about incentives it’s about allocation.

Bottom line is that in the estimation of people who put their money where there mouth is, Niccol is worth the pay.

Addendum: Don’t forget my previous post in this series from 2013, The Value of a CEO looking at what happened when Ballmer exited Microsoft. Same basic lesson but in reverse! N.B. look at what has happened to Microsoft stock since!

All of this should also be put in the context of the Extreme Shortage of High-IQ Workers which one can also understand as the shortage of talent."