Home > Compensation, Internacional Remuneracion, Trends in Corporate Governance > Pay for Performance. (II) Performance metrics.

Pay for Performance. (II) Performance metrics.

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”.

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