REPORTS IN THE PRESS are replete withexamples of what the media depicts as modern-day robber barons. Thecharges have become so commonplace that it now is almost passé to serveup the usual cast of CEOs as poster children of pay excess.
Somewhat surprisingly then, a new Exequity studyof the top 20 companies in the S&P 500, the MidCap 400, and theSmallCap 600 showed that some of the most pilloried CEOs deliveredshareholder returns that handily beat many of the paragons of virtuousexecutive pay. Or that the top executive teams of some of the mostcriticized companies turned in some of the very best “Return onExecutive” scores in 2006.
Most companies as well as investors, in fact,can’t always tell if they are paying for performance. The reason isthat 95 percent of all pay analyses simply look at whether executivesare awarded “competitive pay” opportunities. They add up base salaries,target annual incentive awards, and long-term incentives valued as ofthe date of grant using valuation models such as Black-Scholes forstock options. But importantly, while most financial models acceptBlack-Scholes as a predictor of value, the measurement does notcalculate the amount of pay actually earned. Black-Scholes measures thetheoretical value of the opportunity given at the date of grant,however, from that point forward, the true spread value of the optionis entirely based on stock price, but few seem to be measuring that.
So how might true performance be gauged? Whilecompanies reference a variety of financial metrics, it begs the moreefficient question: Why not just measure stock price performanceitself, as that is ultimately what shareholders are asking ofmanagement? The most rational measurement of pay would then be toconsider what an executive earned during a given period along with theexecutive’s wealth created through the value of his or her equity.
The new proxy rules governing executive pay disclosures now provide abetter platform for gathering pay information that can be compared on aconsistent basis. Exequity has analyzed the new 2007 proxy disclosureswith an eye toward comparing relative measures of shareholder valueadded1 in comparison to the “real cost” of the executive team.2Through measuring the total value forwarded by the company to anexecutive— through all vehicles of compensation, including equityappreciation— and comparing this expenditure to the company’s change inshareholder value over the year, we can derive a fundamentally new wayof looking at compensation, the company’s “return on executives” or ROX.
Large-Cap Companies and the Top 5 Themedian ROX score for the 20 largest companies in the S&P 500 — thatis, the median amount of shareholder value delivered in 2006 for eachreal dollar of total pay for the top five executives was $299. Thereare numerous surprises: Several pilloried companies and their executiveteams score quite high on the ROX metric while some companies viewed asbeing exemplary in their executive pay practices do not.
CEO Pay at Large-Cap, Mid- Cap and Small-Cap CompaniesWe expanded this analysis by looking at the CEO’s pay at each of thestudy companies. As expected, the value enhancement for each dollardelivered to the CEO was lower for the smaller companies. The medianshareholder value delivered for each dollar of CEO pay in 2006 for themid-cap companies was $73, versus $66 for the small-cap companies. Therange of ROX scores for these companies was tighter than for large-capcompanies, reflecting the greater leverage a top executive group canapparently make at a large company.
The ROX scores generally tend to bear out thenotion that executives of large companies have the potential to presideover more substantial value creation, and that, when they do, thereturn on the pay delivered to the executive group reflects moreextreme results. We believe that the ROX metric provides companies witha useful tool to evaluate the executive team’s performance over time inrelation to executives at peer organizations, and to gain a betterunderstanding of how wellspent the company’s executive pay truly is.
Overall, the ROX coefficient seems to be animprovement over the more typical analysis that currently is performedto determine the cost of the executive team in relation to shareholderwealth generated under the executives’ stewardship. After all, isn’tthat ultimately what shareholders are asking—to get the best bang fortheir buck?