Learning about CEO Ability and Stock Return Volatility

When there is uncertainty about a CEO’s quality, news about the firm causes rational investors to update their expectation of the firm’s value for two reasons: Updates occur because of the direct effect of the news, and also because news leads investors to update their assessment of the CEO’s quality, which changes expected future cash flows. As a CEO’s quality becomes known more precisely over time, the latter effect becomes smaller, decreasing the stock price reaction to news and lowering stock return volatility over the CEO’s tenure. We formally model this idea, and evaluate its implications using a large sample of CEO turnovers in U.S. public firms. Our estimates indicate that there is statistically significant and economically important market learning about CEO ability, even for CEOs whose appointments occur for exogenous reasons. Consistent with this model, stock return volatility and the absolute value of stock price reactions to news, decline with CEO tenure in a convex manner. The decline is faster when there is higher ex ante uncertainty about the CEO’s ability and more transparency about the firm’s prospects. In addition to uncertainty about fundamentals, uncertainty about management quality appears to be an important source of stock return volatility, suggesting that management quality is an important factor determining firm value. JEL classification: G32, G34, M12, M51