2013: Performance Metrics and Their Link to Value

February 20, 2013

Prepared and Published by Farient Advisors LLC

Sponsored by the State Board of Administration of Florida

February 2013

Executive Summary

One clear outcome from say-on-pay voting on executive compensation has been a focus on pay for performance. To determine how well executives are aligned with the long-term performance of their companies, investors are evaluating to what extent executive compensation, particularly for the CEO, is linked to company performance, as opposed to being based on the passage of time – what is sometimes referred to as “pay for pulse.”

As the prevalence of performance-based compensation rises, it is incumbent upon boards to become increasingly discerning about how that performance is being measured. The performance metrics selected, as determined by the company and its board of directors, are deemed to be the best measures of corporate success. Investors and other interested stakeholders wish to validate that these metrics are in fact linked to Total Shareholder Return, or TSR.

Shareholders are increasingly augmenting the discussion on how much compensation is performance-based with how that performance is being measured. They want to understand what metrics are used in performance-based long-term incentive (LTI) plans, why those measures were chosen, and how performance against those measures impact shareholder value.

This groundbreaking research covers 1,800 companies, 24 industry groups, and fourteen years of data (from 1998 to 2011). It identifies the primary metrics used in executive compensation plans, overall and by industry, company size, and valuation premiums, and then tests these metrics to determine whether those being used have the highest impact on TSR results. It provides the most definitive answer to date on a critical question: are companies choosing their LTI metrics wisely for the most sustainable benefit to shareholders?

 

Key Findings and Conclusions

— Executive compensation design has moved towards LTI components in an attempt to align management interests with those of long-term shareholders; further, those LTIs are now largely performance-based

— Among companies using performance-based LTIs, most (53%) use a mix of TSR and financial measures in their equity LTI plans; others (28%) use financial measures only; and a smaller minority (15%) use TSR only. This use rate puts a premium on getting the financial measures right

— In aggregate, performance metrics are generally well-aligned with shareholder value. Earnings Growth, followed by Returns and Revenue Growth, has the greatest impact on TSR. In general, this matches the use patterns for financial metrics in LTIs: Earnings Growth is the most popular financial measure, followed by Returns and Revenue Growth. TSR (usually measured on a relative basis) is used as a direct measure of shareholder value in more th an 40% of companies with performance-based LTIs

— Many industries have a number of metrics to choose from. Half of the 24 industry groups studied have at least three metric categories with strong correlations

— However, the optimal use of measures differs considerably by industry. Industry group, in general, as an indicator of business model, has the strongest influence on performance metrics used, with size and valuation premiums having little impact on metric selection

— The good news is that half of the 24 industry groups use metrics that most highly correlate to value, and also use TSR as a direct measure of shareholder value

— The bad news is that the other half of industry groups could use some improvement. The companies in these industries either are not using the metrics that are most strongly correlated to value or, when the overall correlations of financial metrics to shareholder value are poor, they are not sufficiently using TSR as a direct measure of shareholder performance. More specifically, the most significant improvement opportunities in these industries include:

  • Greater need to use TSR directly when correlations to value are poor
  • Need to balance growth with a greater use of efficiency measures, like Returns and/or Margins
  • Greater need to take capital investments into account, not just the earnings from those investments
  • Recognition that Revenue Growth can be a close second in correlation to value compared to Earnings Growth, offering the opportunity to supplement Earnings with Revenue Growth if indicated by the company’s strategy and growth opportunities

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Recommended Actions

We predict that metrics will become increasingly important and visible as investors and executives try to better align executive incentives with shareholder interests. This analysis suggests some key steps that investors and companies should take in order to improve that alignment. These include:

— Companies should undertake their own analysis to determine which measures of performance have the most influence on their shareholder value. In this regard, various measurement definitions (e.g., how depreciation, capital expenditures, asset definitions, and other items are treated) could make a significant difference to shareholder value and should be given careful consideration

— Companies should try to find two or three key metrics that appropriately balance growth and returns and demonstrate a proven link to value. However, if overall correlations to value are poor, or only one financial metric correlates to value, then companies should choose a single financial metric, non-financial metrics, and/or TSR, and should support this choice with a strong rationale

— Investors are likely to increase engagement activities around executive compensation in general, and specifically on performance metrics. In communicating with investors, companies should present (and investors should expect) compelling evidence as to how various measures of performance will lead to enhanced shareholder value

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We hope that this analysis is illuminating for investors and companies alike, and that it contributes to the quality of the dialogue around how incentive programs, and the metrics that drive them, can enhance shareholder value and support the alignment between pay and performance.

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