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Metrics Misused: The Executive Pay Example

Stephen Davis and Jon Lukomnik | December 9, 2014

Here is a fact, not an opinion: Creating sustainable, long-term value turns out not to be a central driver of executive compensation today.

As counter-intuitive as that observation seems, it is the core finding of a recent report which focused a white-hot spotlight on “The Alignment Gap Between Creating Value, Performance Measurement, and Long-Term Incentive Design Sustainable.” Written by Organizational Capital Partners in collaboration with the Investor Responsibility Research Center Institute, the study builds from a premise familiar to anyone who has taken Finance 101: Value creation demands that return on invested capital (ROIC) be greater than the weighted average cost of capital (WACC). You can survive for a period of time, perhaps even an extended period of time, burning through capital. Indeed, many start-up companies, and even new projects within established companies, do so. At some point, however, a company needs to become profitable. So you would think companies would incentivize their senior officers to achieve real economic profitability, but they don’t.

Simply put, three-quarters of large public companies do not use any balance sheet or capital efficiency metrics in their long-term incentive plans (LTIPs). As a result, boards can have no idea whether value is being created or destroyed when they approve bonus payouts. Perhaps as a result, researchers found, only 12 percent of the variance in CEO pay is attributable to economic performance. By contrast, about five times as much is explained by factors such as company size, industry, and pay level of the previous CEO.

Divorcing pay from performance has real-world consequences—troubling ones. Nearly half the companies in the S&P 1500, some 47 percent, actually destroyed value by earning a ROIC less than their cost of capital over the five year period ended 2012.

How did we get to such a state? In short, boards, institutional investors, and proxy advisory firms have insisted that executive compensation center around “alignment” of CEO and named officer compensation with short-term market returns, rather than on creation of economic value over time. One indication is that total shareholder return (TSR) has become, by far, the dominant metric for incentive compensation, despite TSR’s having nothing to do with value creation, when you think about it.

TSR is, instead, a post-hoc measure of the co-movement of stock price and dividends compared to executive pay. If TSR declines by 9 percent, and executives get paid 9 percent less, that’s perfect alignment. (Although nobody—not the CEO, not investors, not the board—will be happy.) Compounding the problem is that executives can’t manage to TSR; their decisions can have only so much affect on stock price. Exogenous factors ranging from Federal Reserve Bank monetary policy, to Russia’s actions in the Ukraine, to the flow of funds into the market, all affect TSR. Yet TSR is a key metric in more than half of all LTIP plans, more than any other measure.

When investors began advocating for alignment a quarter of a century ago, there was an assumption that corporations were run for long-term value creation. Alignment was a secondary goal; investors wanted to make sure the economic profits were fairly apportioned. Somewhere along the line, however, alignment—and TSR—rose to prominence, despite it being uniquely ill-suited as either an incentive or a performance metric.

Advocates for TSR note that it is observable, objective, and measurable. That is all true. But it is also irrelevant; lots of measures boast those attributes.

Advocates for TSR note that it is observable, objective, and measurable. That is all true. But it is also irrelevant; lots of measures boast those attributes. If you lined up CEOs and measured their times in a 40-yard dash, those results also would be observable, objective, and measurable, too. And they would have about as much to do with real value creation as TSR does.

Fight for the Future

What does drive value over time? First, as noted, earning an ROIC greater than a company’s WACC drives value. But remember that a company’s total enterprise value is comprised of two parts: current value and future value. Current value is obvious; it is the net present value of existing economic profit plus capital invested to date. Future value is a bit more complicated. It is the net present value of the not-yet-achieved cash flow from things such as new products or services, future efficiency gains, new markets, and other gains. Future value is also often related to a key intangible: the perceived quality of management. And as tricky as assessing future value might be, it is a vital component in the expansion (or contraction) of price-earnings multiples for public companies. Indeed, depending on the corporation, it can represent 25 to 70 percent of total enterprise value.

Moreover, unlike TSR, drivers of future value (such as new product development) are things that senior management can directly affect. Astonishingly, however, only about 15 percent of large companies include such operating metrics in their LTIPs, the new study found. Perhaps as a result, major inputs into the creation of future value such as research and development investment and net new capital expenditures have declined from 2.9 percent of revenue in 1998 to 1.7 percent in 2012. That is a 41 percent decline on a revenue-adjusted basis. Senior managers are by and large not rewarded for those kinds of investments.

Perhaps we shouldn’t be surprised. When you take a step back, a theme runs through the findings, that boards have placed strong emphasis on short-term stock price movement. Consider, for example, that 90 percent of large public companies don’t even have a performance period for compensation of more than three years. Even worse, roughly one- quarter don’t even have multi-year performance periods, preferring to use time-restricted stock options.

Just as not measuring capital efficiency has had real-world effects, the combination of a lack of incentives around future value, combined with the short-term nature of most supposedly “long-term” compensation, has also had an effect. Median future value of the S&P 1500 has shrunk from 50 percent of enterprise value to 27 percent in the dozen years ended 2013.

What can a board do to reinvigorate executive focus on creation of long-term value? Start by focusing on the drivers of sustainable growth in enterprise value: Earning a return on invested capital greater than the cost of that capital, and on innovating so as to drive future value. Then, align your performance measurement periods to the time frame over which those innovations will pay. That’s usually more than three years.

In other words, measure the right things and measure them over the right time periods, even if such a course takes you astray from short-term templates crafted by some investors and proxy advisers. Then invest the time and resources to explain that strategy to your long-term investors; big funds today are more than likely to agree with a persuasive case made by credible directors and pitched to best serve shareowner value. Along the way, you might just manage to shake off the tyranny of TSR and short-term stock price movement.