As proxy advisors and shareholders continue to focus on improving the relationship between compensation and shareholder returns, and new pay for performance rules are finalized by the U.S. Securities and Exchange Commission, it is likely that more companies will consider adapting incentives based on Total Shareholder Return (TSR) principles. Ultimately, companies need to balance shareholder value creation with executive motivation and retention when deciding whether a TSR-based incentive plan is appropriate and aligns with the company’s compensation philosophy.
If TSR is utilized in a performance-based award package, companies need to consider the following three factors: whether TSR should be measured on an absolute or relative basis, the appropriate TSR performance hurdle, and whether there will be a cap on payouts based on absolute TSR performance.
1. Absolute versus Relative TSR. Absolute TSR requires the company to set stock price targets that must be achieved to earn a payout. Establishing an absolute stock price level at the beginning of a performance period can be challenging, as a declining stock market could make goal achievement difficult to achieve, while a “buoyant” stock market could make the absolute goal relatively easy to achieve. The challenge with relative TSR is that it requires the company to select a peer group or index that is appropriate for relative TSR performance comparisons. Identifying an appropriate comparator can be particularly challenging for companies in unique markets or industries with just a few competitors.
A well-designed TSR plan might provide that when a company achieves both low absolute TSR and relative TSR, little to no payouts would be allowed (Figure 1, box C); similarly, when absolute TSR and relative TSR performance are high, payouts would be sizable (Figure 1, box B).
In cases of high absolute TSR with low relative performance (Figure 1, box A), some type of reduction in payouts might be appropriate, as the company underperformed the stock market. Similarly, in cases of low absolute TSR and high relative TSR performance (Figure 1, box D), management could be rewarded for out-performing a down stock market.
Competitive practice, however, does not often combine these two concepts. Most plans are based on relative TSR, with no adjustment for absolute performance. The few companies that set absolute stock price (or TSR) goals do not consider relative performance. A few large companies have introduced payout caps when absolute performance is negative, a concept which is discussed below.
2.TSR Performance Hurdle. If absolute TSR is utilized, a company will need to decide a minimum stock price level that must be achieved to trigger a payout (e.g., the current stock price is $15, and a trigger price of $30 is established before a payout can be earned). Determining an absolute stock price, or TSR hurdle, should stretch the executive’s efforts, but should not be demotivating. That said, the performance of the overall stock market or the stock performance of the company’s industry sector can make the $30 target in the example either impossible or easy to achieve, which may not create the intended incentive.
For relative TSR, the company must decide the minimum level of relative performance compared to a peer group or market index that begins to provide a payout. This approach allows companies to avoid the need to set a specific stock price. However, it is important to remember that a relative TSR goal may not provide the intended motivation, as the goal is not as clear cut as the absolute stock price target (and, presumably, the underlying earnings or cash flow that must be achieved to support the target stock price).
A typical relative TSR performance curve for a US-based company is illustrated in Figure 2. The threshold level is often the most debated payout level on the performance curve, although competitive market practice suggests the 25th percentile is the most common threshold performance level. By way of contrast, a UK-based company would typically start payouts at 50thpercentile relative performance.
3. TSR Caps. In order to reward both relative and absolute performance, some companies with relative TSR plans have placed a cap on payouts when absolute TSR is negative. These caps often limit payouts to 100% of target despite the company’s ability to outperform in a down market, as shareholders lost value during the performance period.The obvious issue with this approach is the lack of symmetry. Specifically, if the share price increases significantly, but relative TSR is below the threshold level, no payouts will occur. Thus, shareholders will realize a significant increase in stock value and management does not receive a payout (contrast this result with stock options, where management would realize a significant amount of “intrinsic value”). The lack of symmetry and the general belief that out-performance in a down stock market should be rewarded has likely led companies to refrain from imposing caps on payouts.This may change as shareholders and the proxy advisory firms continue to apply pressure on companies to better align pay and performance. In addition, the SEC proposed rules required under Dodd Frank in July 2015 that when finalized will require disclosure of the relationship of pay and TSR (both relative and absolute). This disclosure could impact the design of incentive plans including TSR-based plans to further align realized compensation with shareholder returns (including the use of TSR caps).
Michael Kesner is principal and Jennifer Kwech is senior manager of Deloitte Consulting LLP’s Compensation Strategies Practice.
Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee (“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to clients. Please see www.deloitte.com/about for a more detailed description of DTTL and its member firms.
This presentation contains general information only and Deloitte is not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this presentation.
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.
Using total shareholder return (TSR) as a compensation program metric emerged as a hot topic for both panelists and attendees during the third annual Leading Minds of Compensation event last week at the Grand Hyatt in New York City. Discussing the day’s most pressing compensation issues in a panel selected by NACD Directorship magazine Publisher Christopher Y. Clark and Editor-in-Chief Judy Warner were: Steven Hall, managing director of Steven Hall & Partners; Dayna Harris, vice president of Farient Advisors; Jeff Joyce, partner of Pay Governance; Rose Marie Orens, senior partner at Compensation Advisory Partners; Jannice Koors, managing director of Pearl Meyer & Partners; and Barry Sullivan, managing director of Semler Brossy.
Jannice Koors noted that, while not a practice used by the majority of public companies, TSR is a popular metric. “It has some benefits: it clearly is the most directly aligned metric between shareholders and executives, so it’s an easy story to tell, it rewards results, it’s easy to present to shareholders.” But, according to Koors, the pros of TSR are readily outweighed by the cons. “The purpose of an incentive plan is to incent behaviors, actions, and decision making,” she said. “You don’t have behaviors that create stock price.” Dayna Harris agreed. “TSR doesn’t focus people on things they can control,” she said. “When you go to a one-size-fits-all compensation plan, you are reducing the number of tools in the tool chest that help the board and management to improve overall company performance.”
Koors expressed another major reservation with this metric. “You’re measuring movement over that period of time—it creates some natural spikes. So what goes up must come down. What naturally happens in TSR plans—and what a lot of companies who are coming up on that third and fourth and fifth year of having a TSR plan in place are finding—is that if you’re in the top quartile at the end of your three years, you have vastly improved the likelihood that you are going to be in the bottom quartile at the end of your sixth. So what TSR really rewards is being a steady eddy in the middle of the pack.”
But, during the Q&A portion of the event, one director self-identified as an advocate for TSR as a valid and valuable metric, said it’s the purest way to align shareholders with directors. If companies were to move away from TSR, what data is available to lure away TSR’s most ardent adherents? “I’m not going to try to dispel the notion that it is purely aligned,” Koors said. “I’m just saying it’s a reward, not an incentive—and it depends on what you want your long term incentive plan to do.”
Rose Marie Orens added her thoughts about TSR, saying that there is a time and a place for this metric, particularly in the financial services industry. Though acceptable to use TSR as a portion of an award, and to use it as a reminder that driving stock prices is a priority for executives, Orens didn’t think it should be used as the main metric behind executive compensation. “I would drive either for relative performance on metrics that are important in my industry and I want to demonstrate that I am doing better,” Orens said.
Barry Sullivan directed attendees’ attention to “The Problem with Total Shareholder Return,” a study mounted by his firm in 2012 that gave Koors’ intuition and Orens’ observations a statistical bite. “What do we need to do from a growth and profitability perspective over a long period of time to drive TSR?” Sullivan asked. “When you look at the data, those companies that outgrow at a return above their weighted cost of capital drive superior total shareholder return. Focus on growth, focus on profitability, and TSR will come.”
Jeff Joyce didn’t take issue with TSR in and of itself, but rather, he found fault with its application. He observed that, because TSR is measured over a fixed period of time, a sudden lull in stock price at the end of that period undermines shareholder alignment. “While it does play a role, stock price is captured in other forms of equity,” he said. “It doesn’t have to be explicitly measured in terms of total shareholder return.”
NACD Directorship will host a “Prognosticators of Pay” event on July 17th in Seattle. Directors interested in attending this complimentary program may request an invitation online.
Look for full coverage of NACD’s Leading Minds of Compensation event in the May/June 2015 issue of NACD Directorship magazine.