Ativo Capital

Rigorous Thinking


Financial and economic commentary reflecting Ativo’s world view:

More U.S. Firms Use Nonstandard Accounting Measures to Figure Executive Payouts

Monday, March 3, 2014

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Last Wednesday’s Wall Street Journal (article here, login required) reported that an increasing number of firms are using non-GAAP measures as the basis for executive compensation awards.   Despite the overall negative tone of the article, our perspective is that moving away from GAAP measures isn’t necessarily a bad idea.

In our experience, traditional GAAP measures show minimal statistical relation to enterprise value creation.  A fundamental principle of executive compensation is “you get what you pay for,”  so an executive compensation program that pays based on EPS growth or some target ROE enhances the probability that the firm will deliver the targeted EPS growth or ROE.  But that doesn’t necessarily mean the enterprise creates value for shareholders.   Encouraging firms to use GAAP metrics simply perpetuates this problem.

Make no mistake,  we’re not endorsing bogus EBBS (Earnings Before Bad Stuff) metrics that conveniently justify higher executive payouts.  But non-GAAP metrics aren’t all created equal.  Rather, our practice has long been to focus on the fundamental economics behind the GAAP conventions, things like cash generation and the real value of physical assets that drive genuine value creation.    That’s a key part of how we manage portfolios, and from our perspective, that’s how it makes sense to pay executives.  

Sure, GAAP measures are audited, easy to report, and generally understood.  But for us, the key decision point is whether metrics empirically link to value creation.   If they don’t, then let’s move on to something that does.

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