Total shareholder return (TSR) has become an incredibly important metric for boards to use to determine executive compensation, with over half the firms in the S&P 500 implementing the metric—a number up from fewer than one in five a decade ago. TSR as a metric is deeply flawed, though. It overrates weak companies that merely recovered from depressed valuations, and unfairly demotes elite firms that have slipped, even slightly, or that failed to live up to unrealistic expectations. It’s also distorted by leverage. Say two firms perform exactly the same. The one with more debt and less equity produces a higher TSR on the upside and a lower one on the downturn. TSR also is silent about how managers can actually make better decisions. It is a way to keep score, not a formula to win the game.
Enter the Corporate Performance Index (CPI). The CPI is a four-pronged test that accurately sums up the totality of corporate performance from a shareholder point of view in a composite percentile score. CPI is correlated to TSR rankings at a rate of 60 percent, so it adds weight and credibility to the TSR verdict for most companies while revealing what’s behind it. The other 40 percent of the time, CPI provides a different—and usually far more accurate—assessment of how well a company is performing.
The four ratios used in CPI are interesting in their own right. They are:
Wealth creation: the firm’s total market value premium to its book capital, stated per unit of sales (we call the valuation premium MVA, for market value added);
Profitability: the firm’s economic profit, expressed as a profit margin ratio to sales (the term we use for economic profit is EVA, standing for economic value added; it is the profit remaining after deducting a full cost-of-capital interest charge on the firm’s debt and equity capital and repairing accounting distortions that run counter to business logic);
Profitable growth: the trend growth rate in the firm’s EVA profit over the most recent three years; and
Strategic position: the long-run growth in EVA that investors have factored into the firm’s share price, effectively a “buy-side” consensus outlook.
There’s an important, consequential link among these metrics. MVA measures the wealth of the owner, and is the difference between the money put into a business and the value coming out of it. Boards should monitor MVA because shareholder returns come directly from this metric. TSR, in fact, is simply the rate of wealth creation, per unit of value. It comes from increasing the MVA premium over time. Market value added, in turn, comes from EVA. It is mathematically equal to the present value of the EVA profits the market forecasts a firm will earn. This means that increasing EVA is ultimately the real key to driving TSR, making it an ideal tool to manage a business and make better decisions.
CPI, then, is a distillation of EVA and MVA into an overall index of financial excellence. It assigns the highest scores to firms that have achieved the best records of profitable growth, that preside over the most valuable and profitable business franchises, and that are strategically best positioned to continue robust growth above the cost of capital for years to come, compared to peers. Firms like those are truly excellent, no matter what their recent TSR may be, and firms with low or declining CPI scores are really in trouble, even if TSR looks good.
Boards should turn to CPI and the underlying ratio metrics as a complement to TSR. Firms with high CPI scores can use it to repel undeserved say-on-pay criticism and activist overtures, while low scorers can stay on high alert. There’s also a case that TSR’s role in long term incentive plans should be diminished, and that managers should be rewarded instead for increasing the firm’s EVA profits over time. Turning instead to CPI could lead to better decisions, better incentives, better return to shareholders, and an even greater alignment between pay and performance.
Bennett Stewart is an expert in shareholder value and corporate performance management, and CEO of EVA Dimensions, a financial technology firm, and creator of the EVA and CPI frameworks used by the Dow Chemical Company and others.
Director compensation continues to gain attention in the corporate governance community. Once one of the most mundane topics of corporate compensation, director pay is becoming the topic du jour as governance experts and current board members alike debate the value of a strong, engaged board of directors, as evidenced by the fact that ISS now assesses director compensation levels on a relative basis using QuickScore, its analysis and rating system for corporate governance practices. All of this prompts the question: What is a quality board of directors really worth?
Total board cost (defined here as the sum of cash, equity, pension value changes, and all other compensation amounts as reported in the director compensation table of a company’s latest proxy statement) has emerged as another way for directors and other stakeholders to evaluate director compensation and to demonstrate the value of boards to shareholders.
Steven Hall and Partners studied the early proxy filings of 100 U.S.-based companies with revenues in excess of $1 billion. The study examined the aggregate amounts of cash, equity, and other compensation paid to directors, as disclosed in proxy tables. Among this year’s early proxy filers, the median increase of total board fees was 7 percent in 2014, bringing the median total cost to $2 million. The movement in pay was driven by a number of factors, including a median increase of 6 percent in equity awards granted, a 2 percent rise in the cash compensation, and an increase in the number of paid directors.
In addition, we found at median:
Total cash payments to directors increased 2 percent to $777,000
Total equity compensation rose 6 percent to $1.1 million
Total board fees grew 7 percent to $2.0 million
Boards were comprised of nine paid directors, up from eight in 2013
Average cost per director increased 5 percent, to $230,000
We also compared total board cost to revenue, net income, and market capitalization amounts to show the minimal financial impact of director fees. At median, total board cost equals 0.05 percent of revenue, 0.66 percent of net income and 0.03 percent of market capitalization. These figures reinforce the notion that the board continues to represent one of the wisest investments of capital, particularly in light of the experience and specific expertise that directors bring to the companies they serve.
Average Cost per Director
Among the companies studied, average cost per director ranged from $78,617 to $410,678 in 2014. Among the companies reviewed, the median increase over 2013 pay levels was 5 percent. The median average cost per director equaled $229,899 in 2014.
According to the study, the mix of pay delivered to directors remained virtually unchanged in 2014. Equity awards accounted for 55 percent of total board cost, up from 54 percent in 2013. Cash compensation decreased as a percent of total board cost to 42 percent, from 44 percent in 2013. Change in pension values increased to 1 percent of total board cost, from 0 percent in 2013, and all other compensation remained equal to 2 percent of total board cost. The increase in pension values is attributable to changes in actuarial assumptions used to value these programs, rather than a shift in approach; pension programs for directors are no longer a part of most pay programs.
Among the 100 companies studied:
Revenues ranged from $1 billion to $183 billion
Median equals $2.9 billion
Median one-year revenue growth equaled 7 percent
Net income ranged from negative $53 million to $40 billion
Median equals $269 million
Median one-year net income growth equaled 11 percent
One-year total shareholder return grew 10 percent
Action Items for Director Consideration
The recent focus on director pay by shareholders and members of the corporate governance community has prompted a number of important changes in the way directors consider and implement director pay programs. First, consider director pay issues on an annual, rather than a biennial or triennial basis. Staying abreast of market movements with small annual adjustments is generally preferable to larger, sporadic jumps in pay. While the ways of delivering pay (cash and equity retainers, meeting fees, and additional retainers for committee service) may vary depending upon the company, directors should focus on total pay per director as well as the total cost of the board. In addition, companies should remain mindful of how pay compares to that of their direct competitors as well as companies in their peer group, as defined by proxy advisory services like ISS.
As it comes time for your company to conduct its annual review of director compensation, we recommend that you consider the following questions:
Is your director compensation program fair and competitive?
Does the program allow you to attract and retain high quality director candidates?
Is the program justifiable to shareholders?
Are modifications to your director compensation program appropriate and reflective of projected market increases and company growth?
How does your director pay mix compare to the pay mix at companies of similar size and/or industry?
Is your program’s structure aligned with the current best practice of delivering at least half of total value to directors in the form of equity? If your program’s equity awards are denominated in shares, does your company account for the total potential volatility in grant value?
To what degree does your company consider total board cost when making modifications to your director compensation program?
For a more detailed analysis on director compensation, look for Steven Hall & Partners’ annual Director Compensation Study due out later this year.
While the term “shareholder activist” can send a shiver down the spines of corporate directors, there are often positive outcomes from this activity. Janet F. Clark, former executive vice president and CFO, Marathon Oil Corp. and director, Dell, YES Prep Public Schools, Teach for America; Darren Novak, senior vice president, Houlihan Lokey; Brian L. Schorr, chief legal officer and partner, Trian Fund Management; and Andrew E. Shapiro, president, Lawndale Capital Management discuss how and why activist shareholders can be a force for good.
Shareholder activists can take on many forms, and Schorr said activists typically fall into four broad categories: merger and acquisition activism, balance sheet activism, governance activism, and income statement/operational activism—which is the key analysis of his firm. “We want to create long-term shareholder value by focusing on the balance sheet, working closely with management and boards,” he said.
Behind the Scenes Activism
While activists are often making headlines in the media, Shapiro was quick to note the value in trying to engage with a company before going public. “Activism is inherently disruptive and can be costly to stakeholders, directors, and management—and even to activist investors,” Shapiro said. “There is great value in trying to engage with the board and management to resolve issues and determine irreconcilable differences.”
Schorr noted that his firm generally attempts to set up a meeting with the CEO and often a representative from the board to present strategic ideas before going public. “Our goal is to have a voice in the boardroom and persuade the board [that] there might be a different strategy they haven’t considered,” he said.
Activists at the Table
If a board and management are doing their jobs—actively testing strategies, looking at metrics and peer performance, and seeking improvement to increase firm value—they won’t get a knock on the door from activists, Clark said.
If, however, that knock does come, it should not be completely jarring to the company. “If a board is approached by [an] activist with an idea management hasn’t pursued, the activist is doing a positive thing. Management shouldn’t be surprised by concept,” Clark said.