Is the difference in compensation between managers and workers related to the quality of the firm? We propose an asset pricing model with unsophisticated traders and short-sales constraints, in which the optimal wage gap increases with managerial effort. In equilibrium, we show that firms with lower wage gaps should be overpriced. Using a unique data set on German firms' employee compensation, we provide strong support for the model's predictions. We find that a long-short portfolio of stocks with high and low wage gaps, respectively, yields positive and robust risk-adjusted returns. We also show that the overpricing of low wage gap stocks is explained, at least in part, by the presence of inequality-averse investors. Overall, pay inequality within firms has nontrivial implications for stock prices, and seems to reflect fair compensation rather than agency issues.

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Erasmus School of Economics

Dittmann, I, Montone, M, & Zhu, Y. (2018). Wage Gap and Stock Returns. doi:10.2139/ssrn.3226225