Executive compensation is a very important thing to consider when evaluating an investment opportunity. Executives who are improperly compensated may not have the incentive to perform in the best interest of shareholders, which can be costly for those shareholders. While new laws and regulations have made executive compensation much clearer in company filings, many investors remain clueless as to how to find and read these critical reports. This article will take a look at the different types of executive compensation and how investors can find and evaluate compensation information.
Types of Executive Compensation
There are many different forms of executive compensation offering a variety of tax benefits and performance incentives. Below are the most common forms:
- Cash compensation – This is the sum of all standard cash compensation the executive receives for the year. In the proxy statement, the company will list the base salary for each key member of the management team, such as the chief executive officer (CEO), chief financial officer (CFO), legal counsel, director of sales and other divisional heads.
- Option grants – This is a list of all options granted to the executive; the information includes strike prices and expiration dates. Stock options, if used the right way, are a terrific way to inspire management to maximize shareholder value. However, there is a downside to options compensation. For example, management is awarded a significant options grant that is barely out of the money, meaning if the stock price goes up a little, management will be able to exercise options, convert them to common stock and sell the shares to reap a quick windfall.
- Deferred compensation – This compensation is deferred until a later date, typically for tax purposes. However, changes in regulations have lessened the popularity of this type of compensation.
- Long-term incentive plans (LTIPs) – Long-term incentive plans encompass all compensation tied to performance for tax purposes. Current tax laws favor pay-for-performance compensation.
- Retirement packages – These are packages given to executives after they retire from the company. It is customary for some executives to receive health benefits upon retirement for years of service, or other reasonable perks. These are important to watch because they can contain so-called golden parachutes for corrupt executives or be payable regardless of whether the company meets its financial objectives or is even profitable.
- Executive Perks – These are various other perks given to executives, including the use of a private jet, travel reimbursements and other rewards. These are found in the footnotes. Perks paid out to executives at small companies should be subject to even greater scrutiny because this type of greed is more likely to bankrupt smaller companies or contribute to annual deficits.
Finding Executive Compensation
All executive compensation information can be found in public filings with the Securities and Exchange Commission (SEC). The SEC mandates all public companies disclose how much they are paying their executives, how this amount is derived and who is involved in determining pay. The information itself is disclosed in several locations, including:
- Form 8-K: The current event filing can be used to disclose compensation information if the event is related to changes in compensation policies and/or procedures.
- Form 10-K: The annual report filing is always used to disclose yearly compensation information.
- Form 10-Q: The quarterly report filing also contains quarterly compensation information.
- S-1/S-3 Forms: New issues contain executive compensation information relevant for future investors to consider.
Evaluating Executive Compensation
Evaluating executive compensation can be a difficult task for the individual investor. Luckily, there are many tools available to make the process easier. These tools automatically parse SEC filings to pull the numbers and make comparisons designed to give meaning to raw information.
Pay vs. Performance
One of the most popular ways to evaluate executive compensation is by comparing pay and performance. Unfortunately, many executives are given raises and bonuses even when their companies are faltering. Comparing pay to stock performance can help you determine whether executives are overpaid. The specific metric used most often is comparing the change year over year in executive pay increases to the change year over year in stock price. Obviously, if the change in the stock price outpaces the change in pay, the executive is not overpaid. Here is an example of a comparison for Bill Gates, who was Microsoft's CEO between 1975 and 2000 and the company's chief software architect and chairman between 2000 and 2006:
Between 1998 and 2006, Bill Gates' compensation is tied pretty closely to the company's overall performance. When the company makes more money, Gates receives more compensation and vice versa. This is healthy because it provides executives with the incentive to perform well and increase their personal wealth. Trends showing executives receiving a higher rate than performance can mean overcompensation for underperformance, which can hurt investors both in dollars paid out and incentive to perform. (For related reading, see Putting Management Under The Microscope.)
Another popular way to evaluate executive compensation is to compare one executive to his or her industry peers. While market leaders typically have CEOs who are paid slightly more than their industries, the majority of executives should be paid on par with their peers. Here is the same example as above, except this time it's a peer comparison instead of pay vs. performance:
Here we can clearly see that Bill Gates made more than the average executive in his industry over the charted period. Sometimes, if the executive is the founder of the company, or a high-class CEO, he or she may deserve higher compensation. Because Bill Gates is both an industry mogul and the company's founder, this may explain his comparatively higher compensation. Significant deviations between these two in standard non-founder CEOs can indicate that they are overpaid. (To learn more about how to determine whether an executive is overpaid or well paid, see Executive Compensation: How Much Is Too Much?)
Executive Compensation Laws
There have been many new laws passed to help satisfy investor concerns over executive compensation. Changes in SEC reporting requirements have forced companies to include an "Executive Compensation Discussion and Analysis" section to accompany future pay documentation in all SEC forms. This section requires a "readable" explanation of how the compensation was determined and what it encompasses.
Other laws have been more direct in curbing practices the companies themselves use. One prime example of this was the removal of the deferred compensation tax shelter that helped many executives avoid millions in taxes. Moreover, improvements in other tax loopholes have made it much harder for boards to justify large payouts and hide these payouts from investors.
The Bottom Line
Executive compensation is a very important issue for investors to consider when making decisions. An improperly compensated executive can cost shareholders money and can produce an executive who lacks the incentive to increase profits and boost share price. Meanwhile, the government is working to curb the problem with new laws that close loopholes and make the process more transparent. Combined with new analysis tools, investors are now much more informed.
(For related reading, see: Lifting The Lid On CEO Compensation.)