Quantifying Managerial Ability: A New Measure and Validity Tests

TLDR: A measure of managerial ability, based on managers' efficiency in generating revenues, which is available for a large sample of firms and outperforms existing ability measures is proposed, and it is found that the negative relation between equity financing and future abnormal returns documented in prior research is mitigated by managerial ability.

Abstract: We propose a measure of managerial ability, based on managers' efficiency in generating revenues, which is available for a large sample of firms and outperforms existing ability measures. We find that our measure is strongly associated with manager fixed effects and that the stock price reactions to chief executive officer (CEO) turnovers are positive (negative) when we assess the outgoing CEO as low (high) ability. We also find that replacing CEOs with more (less) able CEOs is associated with improvements (declines) in subsequent firm performance. We conclude with a demonstration of the potential of the measure. We find that the negative relation between equity financing and future abnormal returns documented in prior research is mitigated by managerial ability. Specifically, more able managers appear to utilize equity issuance proceeds more effectively, illustrating that our more precise measure of managerial ability will allow researchers to pursue studies that were previously difficult to conduct. This paper was accepted by Mary E. Barth, accounting.