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 is not easy. Investors must ensure that executive compensation is working in their favor.

Here are a few guidelines when analyzing a company's compensation program.

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 explaining their compensation plans.

A pay-for-performance policy is based on the concept that a CEO's compensation reflects the performance of the company.

While most can support the idea of paying for performance, the concept implies that CEOs take on risk. A CEO's fortunes should rise and fall with the company's fortunes. When examining a company's compensation program, check to see how much stake executives have in delivering profits for investors. The following are different forms of compensation and a description of how they can put a CEO's reward at risk if performance is poor.

Cash/Base Salaries

CEOs often receive base salaries well over $1 million. In other words, the CEO is rewarded substantially when the company does well. However, the CEO is also rewarded when the company performs poorly. On their own, large base salaries offer little incentive for executives to work harder and make smart decisions.

Key Takeaways

  • Pay for performance is a compensation strategy to align executive compensation with the company's success.
  • Base salaries for CEOs are often high but offer little incentive for hard work or skillful management.
  • Bonuses that are linked to company performance will encourage CEOs to work harder and make better decisions for stockholders.
  • Stock options can cause CEOS to focus on short-term performance or to manipulate numbers to meet targets.
  • Executives act more like owners when they have a stake in the business in the form of stock ownership.

Bonuses 

Beware of 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 salary is really $1.5 million.

Bonuses that vary with performance are another matter. CEOs who know they'll be rewarded for performance do tend to perform at a higher level because they have an incentive to work hard.

Performance can be gauged by any number of things such as profit 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 their job.

Executives can be unfairly penalized for one-time events and tough choices that might hurt performance in the short term or cause negative reactions from the market. It's up to the board of directors to create a balanced set of measures that assess the CEO's effectiveness.

Stock Options

Companies trumpet stock options as one way to link executives' financial interests with shareholders' interests. However, options are also have flawed as a form of compensation. In fact, with options, risk can be badly skewed. When shares go up in value, executives can make a fortune from options. But when share prices fall, investors lose out while executives are no worse off. 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 find that common stock ownership is the most important performance driver. CEOs can truly have their interests tied with shareholders when they own shares, not options. Ideally, that involves giving executives bonuses on the condition they use the money to buy shares. Let's face it: top executives act more like owners when they have a stake in the business.

Finding the Numbers

You can find information on a company's compensation program in its regulatory filings. Form DEF 14A, filed with the Securities and Exchange Commission (SEC), provides summary tables of compensation for a company's CEO and other of its highest-paid executives.

When evaluating the base salary and annual bonus, investors like to see companies award a bigger chunk of compensation as a 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 number of awards received by executives in the year. It also discloses re-pricing of stock options.

The proxy statement shows data on executives' beneficial ownership in the company. However, note the table's accompanying footnotes. The footnotes show how many of those shares the executive actually owns and how many are unexercised options. Again, be reassured when you find that executives have plenty of stock ownership.

Fast Fact

Annual bonuses that do not vary with the company's performance are merely additional base salary for CEOs.

Conclusion

Assessing CEO compensation is an art. Interpreting the numbers is not straightforward. However, investors should get a sense of how compensation programs can create incentives— or disincentives—for top managers to work in the interests of shareholders.