By Cydney Posner
This link is to an interesting column by Gretchen Morgenson in Sunday's New York Times. The column takes issue with the common practice of tying executive compensation to stock price, a practice followed by many companies, as well as ISS and other proxy advisory firms, which place great weight on total shareholder return. Typically, the theory is that, if total return has increased, then shareholders "have no right to complain about what might otherwise look like outsize pay at their companies. While this pay posture is understandable, it raises a question: Should a rising stock price inoculate top executives from criticism over their pay? To more and more experts in corporate finance and pay issues, the answer is no." The problem is that "stock price does not always reflect real economic value."
According to one finance professor, a strong believer in markets, "sometimes we need more attention paid to what did this management do to the value of the company and less to what did this management do to the price of the stock….I would like to see compensation systems where managers are rewarded based on what kind of projects they are working on and how big their returns on invested capital are." Another commentator cited statistics showing that "70 percent of executives' stock option gains are attributable to the market's movement as a whole….We are basically paying C.E.O.'s for floating on their backs when we should be paying them to win races."
Instead of relying so heavily on this single measure, one consultant "is urging companies' boards to use other measures to assess whether their executives are truly creating value for shareholders or destroying it. The best measure, he says, is a company's net returns on its invested capital. That is, how much it is generating on its capital investments — plants and equipment, say — minus the costs of that capital, whether debt or equity. ‘Management should be providing value that exceeds its cost of capital [the consultant said.] A company with a negative return on capital can't generate enough free cash flow to pay dividends and enhance the value of the firm over time.' In spite of this relatively simple concept,… few companies appear to use net returns on invested capital, also known as economic profit or loss, when determining executive pay. This is something of a disconnect, given that these returns are a crucial measure of how effectively a company is deploying its capital into projects that pay off, and are certainly figures that chief executives and their finance colleagues watch closely. Moreover, returns on capital are a useful measure across industries. "
According to the column, there are a number of problems with the focus on TSR. First, it leaves out "a wide array of measures that better capture whether a company's management is operating in the interests of investors with a long-term horizon." In addition, it "allows top executives to reap the pay benefits associated with a short-term bullish stock market, which may have nothing to do with their company's specific business or operations, pay experts contend."
In fact, the column contends, perhaps most important, total shareholder return "can rise even after a company has shown an economic loss — a negative return on capital — over an extended period. A focus on stock price, therefore, can mask a longer-term decline in a company's financial footing." WorldCom is one example cited of a company that had returns on invested capital that were below its cost of capital. From "1993 to 2000 return on invested capital at WorldCom ranged from 2.23 percent to a high of 9.5 percent, but the company's cost of capital was more than 10 percent throughout this time. For much of that time period, WorldCom's stock price was rising." The company collapsed in 2002.
The consultant considers "these kinds of companies ‘value myths' because on the surface they are producing gains for shareholders but underneath they are generating negative returns on their investments in plants, equipment, acquisitions or other items." The column includes a table http://www.nytimes.com/imagepages/2013/10/13/business/gret-graphic.html?ref=business identifying eight large companies that, for each of the five years through December 2012, generated a negative net return on invested capital. Still, all but three had shareholder returns that beat the S&P 500 over the five-year period, and all but a different three received broad support for their say-on-pay proposals. '
The column urges that boards and shareholders must bear some responsibility for this result: "A failure to weigh a variety of performance metrics that can warn when a company isn't creating long-term shareholder value is the responsibility of the company's board." And shareholders need to be more diligent in monitoring returns when voting on pay practices "because companies that do not earn positive returns on their invested capital may not be able to pay dividends to shareholders. And those dividends make up one of the bigger income streams that pension managers look for to meet their obligations to retirees." However, the proxy records of some of the larger private money managers showed "broad support" for management and pay practices at the eight companies referred to above.