The Art and Science of Measuring CEO Performance

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The long-term performance of a company’s stock may be the ultimate test of a CEO’s talents. But that’s not the only measurement used by boards of directors to gauge how well the boss is doing.


Experts at Wharton and elsewhere say that companies use many different metrics — all of which can be fine-tuned to fit a company’s circumstances. They also say that, even though hard numbers play a critical role in determining short- and long-term remuneration, compensating a CEO can sometimes be as much an art as a science.


Indeed, any number of factors can effect the way CEOs are judged by their boards, including a particular management style (think Robert Nardelli and Home Depot); an especially challenging industry (automobiles and labor unions); soft metrics (such as customer satisfaction or R&D); the influence of increasingly well-informed shareholders, and an organization’s age (start-up vs. mature company).


Earnings Growth Most Critical


The metrics used by boards “are all over the road,” says Charles M. Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, and may include such figures as earnings per share, return on equity, return on assets, return on capital, revenue growth, cash flow and EBITDA, or earnings before interest, taxes, depreciation and amortization. “Typically, it’s a blend of earnings targets, sales targets, sometimes the success or failure of dispositions or acquisitions,” he notes. “The stock price is a part of it, too.”


Of all the potential metrics, earnings growth is among the most critical. “It captures how well a CEO is running the business,” says Mary Ellen Carter, a Wharton accounting professor. Adds Brian Cadman, an accounting professor at Northwestern University’s Kellogg School of Management and currently a visiting professor at Wharton: “Earnings is generally considered a good metric because it provides a summary measure of value added to the firm over a given period.” But regardless of which specific performance metrics are used, “it is important to compare them to historical values or to a ‘peer’ group of firms,” Cadman says.


Wharton accounting professor Wayne R. Guay says most of the financial incentives provided to CEOs and other senior executives are based on their company’s stock price. “These executives hold large portfolios of stock and stock options that tie their wealth to shareholder performance pretty closely,” Guay says. “For the typical CEO, that is the lion’s share of the incentive.”


At the same time, Guay adds, most compensation packages also include annual bonus plans that tie compensation to financial performance measures like earnings per share, return on equity and various types of corporate income. A company might also have a long-term performance plan involving restricted stock shares, where a portion of a CEO’s compensation is tied to a longer-term measure, such as three years of growth in earnings per share or return on investment. “I don’t think there is just one measure that’s the best performance measure and dominates all others in frequency of use,” Guay says.


Other, non-financial measurements, such as customer satisfaction, may play a role in determining compensation, Carter adds. “Depending on what the firm needs to be focused on, it can structure compensation to measurements in that direction.” Indeed, Gregg Passin, a principal at Mercer Human Resource Consulting in New York, suggests that companies may include internal goals — such as racial diversity and employee satisfaction — as part of the mix of performance measures.


Citing Robert Nardelli’s well-publicized departure from Home Depot, Passin also notes that a CEO can run afoul of a board as a result of an abrasive management style or some other important, yet hard-to-quantify, reason. “A good board will look at many things, not just the stock price or operational measures.”


According to Northwestern’s Cadman, there can be disadvantages in using softer metrics, such as customer satisfaction or success in research and development projects. Success in customer service may improve revenue and earnings in the future, but it may be difficult to assess whether it is boosting revenue and earnings in the current quarter or over the next year.


A growing number of companies are using performance measures as long-term incentives for chief executives. According to the Mercer Human Resource Consulting 2006 CEO Compensation Survey, the number of CEOs receiving shares of stock based on performance, including performance-contingent restricted stock, rose from 111 in 2005 to 178 in 2006. The survey, which included 350 large public companies, was released in April 2007.


The New “Discussion” Section


As a result of new government regulations, stockholders now have more information available to them than ever about how a firm measures CEO performance and how those measures are used to determine compensation. Instead of just reporting the compensation of their top five executives, companies now must include a “discussion” section that explains how compensation is determined. The new disclosure requirements took effect with annual proxy statements filed with the Securities and Exchange Commission after December 2006. Those statements began showing up in the mailboxes of shareholders in the spring 2007 reporting season.


“Things used to be nebulous,” says Wharton’s Carter. “Now, shareholders are getting much more detailed information as to how boards structure executive pay.”


Elson agrees that the new SEC disclosure requirement is a good thing. “The more information that the marketplace has about how compensation is formulated, the more informed shareholders are and the better decisions they can make to elect or not elect a director,” he notes. “I’m a fan of greater disclosure. It [the corporate proxy] is much fuller, particularly on things such as perks, which were not as clear before.”


For example, in its most recent proxy statement, Bank of America’s compensation committee sets forth — in an easy-to-read table — five “performance measures” and the “reasons” that the committee uses those measures. The measures are: revenue, net income, operating earnings per share, shareholder value added and total stockholder return. “Our financial success begins with our ability to grow revenue,” the proxy explains, but it also emphasizes that revenue growth is not sufficient “unless it leads to growth in our net income.”


In explaining operating earnings per share, the proxy states that the compensation committee looks “to this measure to make sure that our net income growth is being achieved over time in a manner that is accretive for our stockholders.” It goes on to say that the inclusion of shareholder added value as a metric “places specific focus on whether the investments we make in our businesses generate returns in excess of the costs of capital associated with those investments.” The proxy also states that Bank of America uses the metric of total stockholder return — which takes into account both stock-price performance and dividends — “as the ultimate means to compare our performance for our stockholders relative to our competitors.”


In a further explanation of its thinking, the committee notes that, as part of its analysis, it looks at “how the financial goals were achieved, taking into account the quality of our earnings. The committee also considers objective data on the successful implementation of strategic initiatives that position us for future growth while also delivering positive total stockholder returns.”


Tying compensation to performance can not only hold an executive’s feet to the fire; it can also provide tax benefits to the corporation, according to Carter. Under an Internal Revenue Service rule designed to rein in executive pay, the maximum amount that a company can deduct annually for compensation is $1 million per executive. But any pay based on firm performance is excluded from this calculation.


“If you have elements of compensation tied to firm performance, you can deduct all of that as opposed to being limited to the $1 million,” Carter says. “So sometimes you see companies saying that they have structured their pay to get maximum deductibility. But this requires that companies have objective ways of measuring performance against the targets they set, and they can’t deviate from them over the course of the year. This exception to the rule is encouraging firms to base pay on performance and to not deviate from what they stated in the beginning as their performance measures.”


Goals for Turnaround Specialists


Sometimes special situations call for special metrics. A troubled company, such as a money-losing auto manufacturer, for example, may not realistically be expected to increase earnings in a short time frame of a year or two. In such cases, the CEO’s performance may be based on how well he or she stanches losses, halts a decline in market share or deals with labor unions. In worst-case scenarios, a board may hire a turnaround specialist to rescue the firm.


“Being a turnaround specialist means having a specific skill set; not everybody is equipped to do that,” says Guay. “These individuals will want a big payoff if things work out well because they know there’s a reasonable chance things won’t work out well. They may have different structures for incentives. Maybe you’re just trying to get the firm out of bankruptcy so it can once again be a publicly traded firm. So maybe you lever up the guy with stock for a long-term payoff, while also establishing some short-term goals for him, like achieving positive cash flow.”


In other cases, the metrics that apply to CEOs of industrial firms may not be exactly the same as those of a financial institution. By the same token, start-up companies may use different metrics than mature companies. “With a start-up biotech or Internet-based firm, earnings may not be a particularly useful measure of performance,” Guay says. “A start-up may not generate earnings for several years, so the board might use a revenue-based system or some other type of performance plan. At the same time, a start-up would be a big issuer of stock, so stock compensation is often a bigger fraction of total compensation for start-ups than for bigger, more stable companies.”


“Veneer of Legitimacy”


Despite stated corporate policies to measure performance and link that performance to pay, some observers say boards still have leeway in how they ultimately assess and reward CEOs and other senior executives.


“While the actual CEO performance-review process varies from one company to the next, given the visibility of the CEO compensation issue in general, ‘hard’ metrics are used more now than in the past as boards try to insulate themselves from charges of dereliction of fiduciary responsibility to shareholders,” states John R. Kimberly, a Wharton management professor. “That said, the metrics are more a veneer of legitimacy than an exclusive tool, and the ultimate decision about the compensation is only loosely linked to performance measures of any sort. So, in that sense, it is as much an art as a science.”


“I would concur [with Kimberly's comment],” says Elson, of the University of Delaware. “There are ‘lies, damned lies and statistics.’ You can always make numbers justify what you want. You can set a metric low enough so that anyone can succeed.” Specific measures can be identified, he adds, “but ultimately it will be a judgment call” in how a board evaluates a CEO.


Cadman disagrees somewhat. “I would argue that firms — and boards of directors — try very hard to link executive pay to performance. While ‘hard’ metrics insulate boards from arguments of excessive pay, including ‘soft’ metrics may improve overall compensation design.”


Over the long run, according to those interviewed, stock performance is the best way to measure how a CEO is doing. And using restricted common stock to motivate CEOs is the best way to compensate them: If the stock price rises in value, the shares the CEO owns are worth more. “One nice feature of stock price is it captures all kinds of information — different assessments of all investors as to how well the firm has done,” says Carter. “In some ways, it’s free of the executives’ ability to manipulate that number.”


“As many financial metrics as there are out there,” each one helps to paint a picture of CEO performance, Elson adds. “But I’ve always believed, in the end, that the ultimate metric is long-term stock price growth. That’s why I think compensation should be in the form of restricted equity held for the long term.”

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