Most companies on a calendar fiscal year have released proxy statements over the past month. In addition to annual reports, intelligent investors must pay close attention to proxy statements to determine the company’s philosophy on executive compensation. Nearly every compensation committee includes what seems like boilerplate statements regarding aligning the incentives of management and shareholders. However, as we have seen on many occasions, such as the example provided by Kraft’s absurd compensation policies, shareholders must be vigilant when it comes to matching rhetoric with reality.
Stephen F. O’Byrne and S. David Young have published a very interesting article entitled What Investors Need to Know about Executive Pay in the Spring 2010 issue of The Journal of Investing. An abstract is available by clicking on the article link and the full article is available for purchase. Mr. O’Byrne is the president of Shareholder Value Advisors and Mr. Young is a professor of accounting and control at INSTEAD.
Value Wealth Leverage and Revenue Wealth Leverage
The alignment of management with shareholder interests should be the ultimate goal of compensation committees. The authors have developed two measures that help shareholders think about how management compensation reacts to changes in shareholder wealth as well as changes in revenues.
Value wealth leverage is defined as the ratio of executive wealth return to shareholder wealth return for a given measurement period. In the case of an executive who also owns all of a company’s stock, the ratio is equal to 1.0 since changes in shareholder wealth create exactly proportional changes to the executive’s wealth. On the other hand, a ratio of 0 indicates no relationship between executive wealth and shareholder wealth.
The authors have also defined a measure called revenue wealth leverage which calculates the ratio of executive wealth return to the percentage change in sales for the measurement period.
Incentives for Value Destroying Growth
Simply having a high revenue wealth leverage is not, by itself, an indication that a manager will pursue value destroying growth because the components of pay that react to changes in shareholder wealth may partly or entirely offset the components of pay that benefit from the revenue growth. The authors test whether there are incentives for management to pursue value destroying growth by assuming a situation where an acquisition would result in a 25 percent increase in revenue and a 15 percent reduction in shareholder wealth.
The question is whether the executive’s action will result in sufficient incremental executive wealth as a result of the revenue gain to offset the loss of executive wealth due to the erosion in shareholder value. The authors use the example of Rex Tillerson of Exxon-Mobil to show that he would have a financial incentive to pursue an acquisition that increases revenue by 25 percent but reduces shareholder value by 15 percent. This observation is particularly interesting in light of Exxon’s planned acquisition of XTO Energy. (Note: This is simply an “interesting observation” on my part rather than a statement regarding whether Exxon’s acquisition of XTO makes sense.)
For more information regarding this research, visit The Journal of Investing website to read the abstract or to purchase the full paper.
Disclosure: The author of this article received a review copy of The Journal of Investing paper from Mr. O’Byrne.