CEO pay: Not how much -- but just how
By Geoff Colvin
July 1, 2003
|
When you think about buying a company's stock, do you care how much the company's CEO got paid? I'm guessing you don't. That is, I'm guessing you don't get the company's annual proxy statement and look up the boss's compensation for the past few years. You can find plenty of information about it -- rows and rows of numbers -- but how much help will this be in deciding whether the stock is a good buy? In most cases, not much.
If this sounds like heresy, I apologize. The outcry over CEO pay waxes and wanes, and right now it has waxed pretty big, so we're all supposed to be foaming at the mouth over the stupendous sums certain CEOs took home last year. And in truth there's plenty to be angry about. CEO pay really did increase substantially last year, just as it did the year before and the year before that, exactly the years when ordinary investors were getting beaten and bruised by the stocks of the companies those CEOs ran. That's injustice, and we Americans hate injustice. So we're mad!
Just one problem: It doesn't get us anyplace. To learn, after the fact, that a CEO got cash by the truckload for poor performance is perhaps a warning about the future, but you sure wish you'd known ahead of time that the company's pay practices would work in this way. In other words, the pay information companies report is enough to make us mad, but it isn't enough to help us much in making investing decisions.
The point was made years ago in a terrific Harvard Business Review article by professors Michael Jensen and Kevin Murphy, and it's just as valid today: It isn't how much CEOs get paid that's important, it's how they get paid. Yet most companies tell investors almost nothing about this vital question. What incentives are the CEO and the rest of the company's executives given? What are the goals in the bonus plan? How does the company measure success and failure?
Most companies don't tell us nearly as much as we'd like to know, but you can still get clues -- if you know where to look and how to interpret the information. Here are some major hints about how a company's top executives are compensated:
The elements of pay. At most big companies, the top team's pay consists of a salary, an annual bonus, some kind of long-term bonus, stock options, and perhaps restricted stock. The relative weighting of these elements can tell you a lot about incentives. If salary is the biggest element (which it rarely is), the CEO has little reason to take risks or grow the company. Stock options are typically the largest element of CEO pay, but are they plain vanilla options? If so, the CEO can make a lot of money even if the stock goes up much less than the overall market. But if they're indexed options, that means the CEO makes money only if the stock beats the market. Restricted stock is increasingly popular, but watch out: This is simply an outright grant of stock, the restriction being that the CEO can't sell it for some specified number of years. All the CEO has to do is hang on till then. Studies have shown that the more restricted stock a company grants, the worse its performance.
The compensation committee's discussion in the proxy statement. Now required by the SEC, this discussion may be just meaningless pap. But it may also hold clues about incentives. Does the comp committee heap praise upon the CEO for making the company bigger, or adding market share, or increasing customer satisfaction? These are nice-sounding achievements that may do nothing for shareholders.
The CEO's contract. Most investors don't know it, but if a CEO has a contract, as most now do, you can probably read it at thecorporatelibrary.com. These documents are fascinating in all kinds of ways. Note particularly what the contract mandates if the company gets bought or if it buys another company -- pay incentives sometimes push a CEO in one of these directions.
Performance metrics How does the company measure its success or failure? To find out, read the company's earnings releases and the CEO's letter to shareholders in the annual report. The CEO is probably being incentivized to make that measure go up. Trouble is, many performance metrics have almost no effect on the performance of the stock, including two of the most popular, earnings per share and EBITDA (earnings before interest, taxes, depreciation, and amortization). For shareholders, the best measure by far is economic profit, sometimes called economic value added (EVA), defined as net operating profit after tax, minus a charge for capital.
By all means get angry over humongous pay for underperforming CEOs. But don't let anger cloud your judgment as an investor. Remember, what you care about most is not how much CEOs get paid, but how they get paid.
|
