Managerial ability, CEO overconfidence, and firm value

Abstract

This study examines the impact of CEO overconfidence on the relationship between managerial ability and firm value. Using a sample of firms listed on the NYSE, AMEX, and NASDAQ exchanges from 1980 to 2019, the analysis reveals that CEO overconfidence weakens the positive association between managerial ability and firm value. Specifically, the value-enhancing benefits of competent managers are reduced when firms are led by overconfident CEOs. The adverse effects are particularly significant in firms with higher levels of free cash flow and lower levels of information asymmetry. High information asymmetry appears to mitigate the negative impact of CEO overconfidence on the relationship between managerial ability and firm value, particularly when firms face financial constraints or lack sufficient internal funds. Further analysis indicates that the intensified adverse effect of CEO overconfidence, observed when free cash flow is high, is attributable to overinvestment, which weakens the positive influence of managerial ability on firm performance. These findings contribute to the literature on cognitive biases in executive decision-making by underscoring the risks of hiring overconfident CEOs, even when they demonstrate high managerial ability. For boards of directors, this study stresses the importance of carefully assessing the interplay between CEO characteristics such as overconfidence and managerial competence during the hiring process, as this combination can have negative implications for future firm performance.