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.)

Cash/Base Salaries
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.

Bonuses
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.)

Stock Options
Companies trumpet stock options as the way to link executives' financial interests with shareholders' interests.

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.

Stock Ownership
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.

Conclusion
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.

Related Articles
  1. Options & Futures

    Use Options to Hedge Against Iron Ore Downslide

    Using iron ore options is a way to take advantage of a current downslide in iron ore prices, whether for producers or traders.
  2. Home & Auto

    Understanding Rent-to-Own Contracts

    They can work for you or against you. Here's how to negotiate a fair one.
  3. Home & Auto

    Avoiding the 5 Most Common Rent-to-Own Mistakes

    Pitfalls that a prospective tenant-buyer could encounter on the road to purchase – and how not to stumble into them.
  4. Home & Auto

    Renting vs. Owning: Which is Better for You?

    Despite the conventional wisdom, renting might make more financial sense than you think.
  5. Personal Finance

    How To Get That Entry-Level Financial Analyst Job

    Landing a job as a financial analyst takes study, strategy and a lot of hard work. Here's how to hone your competitive edge.
  6. Entrepreneurship

    Top 10 Side Jobs You Could Start Now

    Ways to make extra cash in your spare time.
  7. Investing Basics

    Explaining Options Contracts

    Options contracts grant the owner the right to buy or sell shares of a security in the future at a given price.
  8. Home & Auto

    When Are Rent-to-Own Homes a Good Idea?

    Lease now and pay later can work – for a select few.
  9. Retirement

    Why are 401(k) contributions limited?

    Find out why contributions to 401(k) retirement plans are limited, including what the current contribution limits are and how limits encourage participation.
  10. Stock Analysis

    Why Walmart Raised Its Minimum Wage

    Read about the potential pros and cons of Walmart's promise to increase its minimum starting salary to $10 an hour.
RELATED TERMS
  1. Implied Volatility - IV

    The estimated volatility of a security's price.
  2. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  3. Normal Profit

    An economic condition occurring when the difference between a ...
  4. Theta

    A measure of the rate of decline in the value of an option due ...
  5. Derivative

    A security with a price that is dependent upon or derived from ...
  6. Security

    A financial instrument that represents an ownership position ...
RELATED FAQS
  1. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  2. What is the difference between AGI (adjusted gross income) and gross income?

    In the United States, individuals pay taxes based on their adjusted gross income, or AGI, rather than their gross income. ... Read Full Answer >>
  3. Does my employer's matching contribution count towards the maximum I can contribute ...

    Contributions to 401(k) plans come from employee salary deferral and employer match dollars. According to the IRS, employees ... Read Full Answer >>
  4. What are the main risks associated with trading derivatives?

    The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks. Derivatives ... Read Full Answer >>
  5. How can an investor profit from a fall in the utilities sector?

    The utilities sector exhibits a high degree of stability compared to the broader market. This makes it best-suited for buy-and-hold ... Read Full Answer >>
  6. What is the difference between derivatives and options?

    Options are one category of derivatives. Other types of derivatives include futures contracts, swaps and forward contracts. ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!