Product Market Peers and Relative Performance Evaluation

Relative Performance Evaluation (RPE) theory predicts that firms filter out common shocks (i.e., those affecting the firm and its peers) while evaluating CEO performance, and that the extent of filtering increases with the number of firms in the peer group. Despite the intuitive appeal of the theory, previous tests of RPE find weak and inconsistent evidence. We hypothesize that one reason for the mixed evidence is the inaccurate classification of peers. Rather than using static, pre-defined Standard Industry Classifications (SIC), we exploit recent advances in textual analysis and define peers based on firms’ product descriptions in their 10-K filings (e.g., Hoberg and Phillips (2015)). This alternative classification not only captures common shocks to firms’ product markets more effectively, but also tracks the evolving nature of these product markets, as 10-Ks are updated annually. Using product market peers, we find three pieces of evidence consistent with RPE – (i) firms on average filter out common shocks to performance measures, (ii) the extent of filtering increases with the number of peers, and (iii) firms completely filter out common shocks in the presence of a large number of peers. We are able to replicate the first finding but not the others using SIC codes. Overall, our results suggest that a key identification strategy to testing RPE theory lies in accurately defining the peer group.