It's hard to read the business news without coming across reports about the salaries, bonuses, and stock option packages awarded to chief executives of publicly traded companies. Making sense of the numbers to assess how companies are paying their top brass isn't always easy. Is executive compensation working in the favor of investors? Here are a few guidelines for checking a company's compensation program.
TUTORIAL: The Greatest Investors
Risk and Reward
Company boards, at least in principle, try to use compensation contracts to align executives' actions with company success. The idea is that CEO performance provides value to the organization. "Pay for performance" is the mantra most companies use when they try to explain their compensation plans.
While everyone can support the idea of paying for performance, it implies that CEOs take on risk: CEOs' fortunes should rise and fall with companies' fortunes. When you are looking at a company's compensation program, it's worth checking to see how much stake executives have in delivering the goods for investors. Let's take a look at how different forms of compensation put a CEO's reward at risk if performance is poor. (For more on this, check out Evaluating Executive Compensation.)
These days, it's common for CEOs to receive base salaries well over $1 million. In other words, the CEO gets a terrific reward when the company does well, but still receives the reward when the company does badly. On their own, big base salaries offer little incentive for executives to work harder and make smart decisions.
Be careful about bonuses. In many cases, an annual bonus is nothing more than a base salary in disguise. A CEO with a $1 million salary may also receive a $700,000 bonus. If any of that bonus, say $500,000, does not vary with performance, then the CEO's real salary is $1.5 million.
Bonuses that vary with performance are another matter. It's hard to argue with the idea that CEOs who know they'll be rewarded for performance tend to perform at a higher level. CEOs have an incentive to work hard.
Performance can be gauged by any number of things, such as profits or revenue growth, return on equity, or share price appreciation. But using simple measures to determine appropriate pay for performance can be tricky. Financial metrics and annual share price gains are not always a fair measure of how well an executive is doing his or her job. Executives can get unfairly penalized for one-time events and tough choices that might hurt performance or cause negative reactions from the market. It's up to the board of directors to create a balanced set of measures for judging the CEO's effectiveness. (Learn more about judging a CEO's performance in Evaluating A Company's Management.)
But options are far from perfect. In fact, with options, risk can get badly skewed. When shares go up in value, executives can make a fortune from options - but when they fall, investors lose out while executives are no worse off than before. Indeed, some companies let executives swap old option shares for new, lower-priced shares when the company's shares fall in value.
Worse still, the incentive to keep the share price motoring upward so that options will stay in-the-money encourages executives to focus exclusively on the next quarter and ignore shareholders' longer term interests. Options can even prompt top managers to manipulate the numbers to make sure the short-term targets are met. That hardly reinforces the link between CEOs and shareholders.
Academic studies say that common stock ownership is the most important performance driver. So, one way for CEOs to truly have their interests tied with shareholders is for them to own shares, not options. Ideally, that involves giving executives bonuses on the condition they use the money to buy shares. Face it: top executives act more like owners when they have a stake in the business. (If you're wondering about the difference in stocks, check out our Stocks Basics Tutorial.)
Finding the Numbers
You can find a whole host of information on a company's compensation program in its regulatory filing. Form DEF 14A, filed with the Securities and Exchange Commission, provides summary tables of compensation for a company's CEO and other highest paid executives.
When evaluating the base salary and annual bonus, investors like to see companies award a bigger chunk of compensation as bonus rather than base salary. The DEF 14A should offer an explanation of how the bonus is determined and what form the reward takes, whether cash, options, or shares.
Information on CEO stock option holdings can also be found in the summary tables. The form discloses the frequency of stock option grants and the amount of awards received by executives in the year. It also discloses re-pricing of stock options.
The proxy statement is where you can locate numbers on executives' "beneficial ownership" in the company. But do not ignore the table's accompanying footnotes. There you will find out how many of those shares the executive actually owns and how many are unexercised options. Again, it's reassuring to find executives with plenty of stock ownership.
Assessing CEO compensation is a bit of a black art. Interpreting the numbers isn't terribly straightforward. All the same, it's valuable for investors to get a sense of how compensation programs can create incentives - or disincentives - for top managers to work in the interests of shareholders.