Archive for January, 2013

Pay for Performance. (II) Performance metrics.

January 19, 2013 1 comment

There are different ways to assess performance, but the dominant one is connected to financial indicators. It should be remarked that after the 2008 crisis, those indicators have received generic critics as to their failure to drive managers and companies to look for sustainable and long-term success, while in fact, the short-term is said to have been the focus, this being one of the reasons why the crisis has been so deep and resilient. You may agree or not that financial metrics are not easy to be used with a long-term focus, but in any case, non-financial metrics are at least to be analysed.

  1. Financial measures: they are based on the company accounts, (EPS, for instance), or on market values, (TSR).

There are different metrics that can be used, each of them with pros and cons:

a)      Earnings per share, (EPS):

It is a relative metric, so that it can be affected both by altering the earnings (the managers` target) and the number of shares. In principle, the use of the metric intends to take into account the first effect, so net profit. But the option between dividend or stock repurchase programs is then not neutral, and moreover, it damages the capital base or entails excessive leverage.

It also may encourage managers to postpone long-term investments; or it can be manipulated, and affected by macroeconomic factors, far away from the managers` control and actions.

b)      Return on Equity:

It also enhances leverage and financial risk, (think about the financial activities before the 2008 crisis).

c)      Revenue growth: it fails to directly consider profitability.

d)      Cash Flow, Operating Income, or EBITDA.  This metric tries to avoid accounting manipulations/irregularities that arise when profits conversion into cash is analysed.

e)      Total Shareholder return, (TSR): it measures share price appreciation and dividend income, relative to returns from a company’s peer group. It introduces a reckoning of how profits are being obtained, (whether the strategic initiatives are valued by markets as positioning the company to have profits in the future). Provided it is supported by other performance metrics, so that you don`t rely on just a belief of what “markets” thinks management can deliver in the future, it is an acceptable metric.

Even if TSR, combined with some other measures, is dominant in theory and practice, still three themes arise about alternative metrics:

–         Return on Capital, (or assets): it also considers debt, so it avoids the RoE problems. Returns being above the cost of capital, as a prerequisite for long-term sustainability; otherwise, shareholder added value can be measured so that both RoC and cost of capital are considered.

–         Very often, the use of different measures is counseled, so as not to miss some performance perspectives.

–         Metrics should be tailored to each firm, and as they always can be gamed, it is probably a good idea to change them from time to time.

Metrics for turnaround situations: whenever a company faces tough times, or risks bankruptcy, TSR, EPS, and so on, cannot be expected to grow, so that other metrics tailored to the situation can be recommended. Reaching a deal with unions, with a new shareholder that injects cash to the company, halting the share decline, or stopping increasing losses and reverting the trends, can among others, be settled as performance targets to which pay can be tied.

Accountancy based measures are criticized for the uncertainties over the future they include, (asset depreciation, debt collection probability, cost of liabilities – pension, severance, other -).  As for market-based ones, it is often argues they do not necessarily get all information and assessments right.

  1. Non-financial measures.

In the UK, the High Pay Center, (“Paid to perform?”) asserts “Financial incentives have only a limited role to play in the creation of successful businesses”.

So that it recommends the use of non-financial measures, and specifically, log-term focused metrics. Other performance metrics help better asses how a company is performing, such as those referred to:

  • Employees: employee engagement metrics as a proxy for cost saving, reduced absenteeism,
  • Customer satisfaction: a proxy for revenue sustainability, (and given the increasing consumer activism, this will become more relevant in the future).
  • Trust and reputation: tracking this fact is critical in our days, as several cases have shown, where the loss of trust has endangered a company, or even forced it to disappear.
  • Innovation and productivity: those metrics indicate how the company intends to generate future revenue and profits, (innovation versus cost cutting only strategies).

On a broader level, HPC affirms “companies have a critical role to play in society through their investment in staff training, research and development and their contribution to tax revenues. Business also benefits from government investment in infrastructure and public services. There are therefore both practical and moral reasons why company performance measures should reflect the interests of society as a whole”.


Pay for Performance. (I) Pay definitions

January 15, 2013 1 comment

A correct pay definition is relevant when analyzing the connection of Actual Pay to Performance, and its relationship with the universe of peers.

In this post, we will limit to the first concept of the Compensation principle that “Pay” needs to be connected with “Performance”.We will first name and define the main alternative definitions for pay, while taking for given that Performance is well defined, for instance, as represented by Total Shareholder Return, (TSR).

  1. Target or Expected Pay

It includes a total compensation offered to executives in a given year, in an attempt to link his efforts to future performance. Very often, those plans are designed and disclosed around minimum and maximum values, tied to minimum and maximum performance targets.

The problem of “Target Pay” is that it`s more often used on a prospective basis, not in retrospective, which would allow to validate the ties between Pay and Performance.

When Target Pay is used in Proxy filings, it includes Base Pay, Target value of annual cash bonuses and nonequity incentives, target value of any performance-based cash awards, and grant date fair value of long-term equity (options or other) awards.

ISS uses a concept similar to this one. Companies using target pay normally use it to demonstrate the actual ties between Pay and Performance, (perhaps not so easy to explain with other definitions). It shows how the committee intends to link the two variables, but is not useful to show that they were really connected.

  1. Earned Compensation.


It is defined as the “total value of compensation that an executive “earns the right to keep” as cash is delivered and vesting restrictions are removed from equity-linked elements. Long-term cash awards are earned at the end of multi-year periods normally, (so, accrual is not considered in the first years of the multi-year period). RSU are included when they vest, at the vesting day price, and stock options are also included at the Black-Scholes (or intrinsic) vesting day value. In general, Earned value includes elements granted in the year, and some other granted in previous years, (stocks vesting in the year, granted before).


  1. Realized Pay (also named Actual, or Value Received)

This is more accurate to what an executive receives, and can be disclosed with transparency as to whether pay and performance are connected. It includes actual cash compensation, (base salary and bonuses), actual payouts under performance share or cash awards, and exercised or taxable equity incentives, (vested or sold in the period). In progress equity awards –not yet vested- are excluded. If the executive cashes out in the period, the cash amount will equal realized pay, but it he holds equity or options for longer, realized value for that equity will go up (down) with stock price.

So, in summary:

–         Stock options: gains from exercised options.

–         RSU: the value of those vested in the period, (in other versions, those sold by the executive).

–         Performance Shares: value of those vested in the period, (in other versions, those sold by the executive).

Realized pay has also some disadvantages: firms may differently calculate it, as exposed; it introduces external movements in compensation due to investment decisions by managers, (as they decide when to hold or sell the equity component); also, some options or shares granted before the performance period can be counted, if vested, exercised, or sold in the period, (depending on the exact definition used).

  1. Realizable Pay

It is increasingly being adopted by many firms. It includes compensation earned in the period, based on the amount thar can be realized, (so it is counted when paid, vested or realized), that is: actual base salary and bonus, and the value of equity that executives may recognize, based on actual stock performance as of a specified date, so:

–         Stock options: embedded value of those outstanding, (market value minus strike price). The time value is lost, though.

–         Restricted Shares: value of those granted in the period, vested or not, valued at stock price at the end of period.

–         Performance Shares: value of the target number of performance shares, valued at stock price at the end of period. Using the target number, instead of the actual earned number is a flaw of this method.

This allows stock performance to be reflected in the value of equity components, as equity is overlooked over a multiyear period. It includes intrinsic value of all equity awards outstanding, (realized or not in the case of options or SARs), and paid or vested, (RSU or other equity awards). The greater the % of pay is at risk, (equity linked somehow), the better the case for realizable pay is.

Disadvantages are: different calculations used by companies, the fact that it is not “fully actual pay”, as some events eventually affecting stock value in the future, may dramatically change the actual pay to be received. But it is clearly better than target and realized, (as for investment decisions by executives do not affect).

Until January 2013, ISS dismissed this concept, but from then it decided to combine its own with this one: when its analysys shows some concern, a higher stock (lower) price linked to a higher (lower) realizable than grant date value pay would mean there is a certain adherence to the principle.

The doubt remains as for the best day to take stock price values, (end of period, last quarter, an average value….). Additionally, should exercised options, sold equity, or cashed in tools be counted? Not if granted out of the performance period, but shouldn`t the value change in the reporting period also be counted?

  1. Performance-adjusted Compensation

The focus is on stock options, SARs, RSU, and performance shares, (from now on, Equity Long-term incentives, or LTI). Those may be valued at Grant-date value, (as in Target Pay or USA regulation ordered Summary Compensation Tables, (SCT), (using accounting procedures, such as as Black-Scholes), or as in ISS assessments, (using its own procedures). To cope with the problem of Target Pay, Earned, Realized and Realizable pay were defined, but they, as seen, have their own problems.

Performance Adjusted Compensation, is similar to Realizable Pay, but addresses some of the defects. It can be defined as “annualized total compensation after stock price performance is taken into account”. In brief:

–         Stock options: Black-Scholes value of options granted in the period, vested or not, based on stock price at the end of the period. This includes the time value of options.

–         RSU: value of those granted in the performance period, vested or not, at the stock price at the end of the period.

–         Performance Shares: value of those earned and vested during the period, at the stock price at the end of the period.

Whatever standard definition is used, it should follow below principles:

–          Data should be shown over the long-term (e.g., at least three 3-year rolling cycles).

–          All elements of compensation should be valued after performance has happened, not at grant date.

–          The time horizon of the pay components should match the horizon of the performance measured.

–          The pay definition should put the various LTI vehicles on comparable footing, so that pay and performance comparisons are not distorted.

–          The pay definition should make it easy to compare actual pay across companies.

–         The pay and performance discussion should cover total compensation.

–         The data should be readily available and easily replicated by third parties

In the post we followed “Pay definitions:…” by Farient, (, and What Does It Mean for an Executive To Make $1 Million?, by Rock Center Corporate Governance, ( ).