Ativo Capital

Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

Pay for Performance?

Monday, May 17, 2010


It’s that time of year again. Now that the proxy statements are out and shareholder meetings are on the calendar, we’re seeing the latest round of articles and studies (such as this from Business Week) questioning whether CEO’s are being overpaid or underpaid for the performance they’ve delivered.

One major concern with many such comparisons is that they define “performance” as Total Shareholder Return (TSR) over some arbitrary period. A critical (and obvious) problem is that TSR, by definition, requires specific start and end dates for the measurement period. Moving the start date or end date by even one day often results in substantial (and meaningful) differences in TSR, which was the problem in the options backdating scandals not so long ago.

A fundamental (and more subtle) problem lies with the implicit assumption that TSR represents an accurate measure of company performance. TSR encompasses many factors, and actual company performance is just one of them. Sector rotation, a long-term pattern of specific industries falling in and out of favor with investors, represents one extraneous influence on TSR. And this is in addition to broader market trends, which reflect changes in investor discount rates overall. Factor in these two components of TSR volatility and it’s easy to see why employee stock options have acquired a reputation as “lottery tickets.”

With respect to specific firms, there’s the issue of the degree to which changing expectations (which drive TSR) reflect a change in actual performance. Some CEO’s have generated significant stock price gains by creating expectations of improved performance, although these gains quickly erode if the firm then fails to deliver. (And when evaluating CEO performance, do you start counting on the day the new CEO is announced, the day he/she reports for work, or some other starting point?)

Finally, because TSR is a measure of change, a top-performing firm that stays on top of its game may well deliver a significantly lower TSR than a poor performer that becomes less bad. It is up to the compensation committee to determine how much weight to assign to the absolute level of performance compared to changes in performance, but automatic reliance on TSR implicitly makes choices which don’t necessarily provide productive incentives for management.

Many of these factors diminish in importance over long enough time periods, but extremely long horizons are impractical for compensating the many CEO’s who may only be around for a few years. Bottom line, TSR is clearly a critically important metric, but a simplistic reliance on TSR as the sole measure of executive performance creates more confusion than enlightenment. CEO compensation is a complex and controversial subject which isn’t going to be settled in a short blog post, and it isn’t going to be resolved by focusing on any single performance metric.