Download measuring and rewarding performance: theory and evidence

MEASURING AND
REWARDING
PERFORMANCE: THEORY
AND EVIDENCE IN
RELATION TO EXECUTIVE
COMPENSATION
A report prepared
for the CFA Society
of the UK
OCTOBER 2014
Lars Helge Hass
Jiancheng Liu
Steven Young†
Zhifang Zhang
(Lancaster University Management School)
We are grateful for comments and guidance from the Steering Group for this project
– Natalie WinterFrost, James Cooke, Brian Main, Sheetal Radia, Mikkel Velin, and
Alasdair Wood. We are particularly grateful to Mikkel Velin and Rogge Global Partners
for providing advice and data to assist with cost of debt calculations. We would also
like to thank Martin Conyon for his comments and guidance. All views expressed
herein are the responsibility of the authors and do not necessarily reflect the views
of the CFA UK. Any remaining errors are the sole responsibility of the authors.
†Corresponding author: Tel: ++44 1524 594242. Email: [email protected].
Address: Lancaster University Management School, Lancaster University, Lancaster
LA1 4YX. Financial support was provided by the CFA UK.
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EXECUTIVE SUMMARY
Debate surrounding executive compensation is an
enduring feature of the UK corporate landscape. While
concern over compensation levels continue to exercise
politicians, regulators, investors and the media, there is
growing concern over the degree to which performance
metrics commonly used in executive compensation
contracts represent appropriate measures of
long-term value creation. This debate partly reflects
fears that UK executives face excessive pressure to
deliver short-term results at the expense of long-term
improvements in value (e.g., Kay Review 2012).
This report contributes to the debate over executive
compensation generally and in particular to the
question of performance measure choice in executive
compensation contracts. The first part of the report
summarises key insights from the academic and
professional literatures regarding the structure of
executive compensation arrangements and the
metrics used to link pay with corporate performance.
The second part of the report presents findings from a
pilot study of executive compensation arrangements
and their association with corporate value creation
using a subsample of FTSE-100 companies.
Our synthesis of prior research provides the
following findings:
»» Economic theory provides guidance on
compensation plan design and the importance of
linking rewards to observable outcomes. However,
while theory dictates that investment decisions
should be made on the basis of discounted cash
flows and the net present value rule, in theory it
offers little direct guidance on how to measure and
reward managerial performance;
»» An effective performance measure should capture
whether management have generated adequate
returns to capital providers (both debt and equity
investors). Firms create value when they generate
economic profits, defined as returns that meet or
exceed the entity’s cost of capital. Economic
profits differ from accounting profits and returns
to equity holders because the latter metrics do not
include a periodic charge for the cost of invested
capital. Failure to benchmark periodic performance
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against the opportunity cost of funds can lead to
misleading signals regarding the degree of periodic
value creation;
»» In the absence of a first-best measure of periodic
performance, corporate boards and compensation
consultants employ metrics that yield the most
efficient second-best solution to the issue of
measuring and incentivising executive performance;
»» Two features of current UK practice are particularly
striking: (i) the dominance of performance metrics
that capture returns to equity investors such as
earnings per share (EPS) and total shareholder return
(TSR) as opposed to entity-level metrics that capture
returns to all claimholders, and (ii) the dearth of
metrics such as residual income (RI) that benchmark
periodic performance against the cost of capital;
»» Prevailing practice supports concerns expressed
by a range of corporate stakeholders that UK
corporate managers and boards may be failing to
recognise the crucial distinction between paying for
performance and compensating management for
strategic success.
»» The unintended consequences of over-reliance on
narrow, simplistic performance metrics that align
poorly with value creation are well documented
and include: investment myopia, earnings
manipulation, excessive risk taking, and threats to
organisational culture.
»» Much of the debate on the link between executive
pay and corporate performance continues to focus
on strengthening explicit links with conventional
performance metrics (e.g., EPS and TSR) rather than
on the issue of performance metric choice.
To shed further light on executive compensation
arrangements and the link between pay and value
creation, we report results for a pilot study examining
compensation and performance data over the period
2003-2013 for a sample of 30 FTSE-100 companies. Our
analysis seeks evidence on three questions:
1.
What is the degree of alignment between alternative
measures of periodic performance, defined to include
both equity- and entity-level metrics?
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2.How does executive pay align with alternative
measures of periodic performance and in particular
with measures of value creation for all capital
providers?
3.How do performance metrics employed in
executive compensation plans align with the key
performance indicators that drive value at the
individual company level?
Our key empirical findings are summarised as follows:
»» Consistent with extant evidence, we find that
EPS and TSR are the most commonly employed
performance metrics in CEO compensation contracts
throughout our sample period; value-based metrics
such as RI are rarely used;
»» Performance metrics that are commonly used in
CEO compensation contracts (e.g., EPS, TSR and
ROE) display relatively low correlation (< 0.5) with (i)
free cash flows to all capital providers (FCF) and (ii)
returns to all capital providers in excess of the cost
of capital (RI);
»» In relative terms, the correlation between CEO
compensation and both FCF and RI is at least as
strong as for contracted performance metrics
such as EPS and TSR (although findings for FCF are
sensitive to the specific definition employed);
»» In absolute terms, CEO pay measured from a range
of perspectives also displays low correlation (< 0.3)
with firm performance regardless of the specific
performance metric employed;
»» We find some evidence that high reliance on EPS
performance conditions may lead management to
pursue actions aimed at increasing short-term EPS
rather than enhancing long-term value creation.
Although our results are best interpreted as
suggestive given the small sample size, they are
nevertheless consistent with large-sample academic
research documenting similar effects;
»» We report evidence consistent with a material
disconnect between KPIs disclosed by management
and the metrics used to incentivise and reward
senior executives. In particular, approximately
one third of cases display apparent misalignment
between the non-financial drivers of business value
and the performance metrics used to incentivise and
reward CEOs.
Our results provide some comfort but also create cause
for concern. On the positive side, results demonstrate
a material positive association between CEO pay
and several measures of value creation for all capital
providers. The evidence suggests that prevailing
executive pay structures incentivise and reward
important aspects of value creation even though
contractual performance metrics are not directly linked
with value creation in many cases. More troubling,
however, is our evidence that (i) a large fraction of CEO
pay appears unrelated to periodic value creation and
(ii) key aspects of compensation consistently correlate
with performance metrics such as TSR and EPS growth
where the direct link with value creation is more fragile.
Based on our findings we conclude that while
compensation practices in the UK have improved
significantly since Sir Richard Greenbury published
his landmark report in 1995, the journey is far from
complete. Both the explicit link (through performance
measure choice) and the implicit association (as
reflected in observed correlations) between CEO pay
and returns to all capital providers remain weak in
absolute terms. Moreover, since our analysis focuses
on the largest publicly traded firms that tend to
follow best-practice guidelines most assiduously, our
findings likely reflect an upper bound on the strength
of the link between executive pay and fundamental
value creation. We therefore view the issue of
performance metric choice in executive compensation
arrangements as work-in-progress and an area where
significant opportunities for further improvement exist.
INTRODUCTION
Debate surrounding executive compensation is an
enduring feature of the UK corporate landscape.
While changes to disclosure rules and best practice
guidelines have led to significant improvements in the
transparency and structure of executive pay since the
mid-1990s, concern over both the level of pay and its
sensitivity to performance shows no sign of relenting.
From claims of fat cat pay deals for executives in the
utility sector that triggered the Greenbury Report (1995)
to recent outrage over bankers’ bonuses and their
potential role in the recent global financial crisis, the
structure and governance of executive compensation
arrangements continues to make the headlines.
While the overall quantum of executive compensation
and outrage over the magnitude of bonus payments
dominate much of the discussion, a more nuanced
debate focusing on the way performance is measured
and the extent to which commonly employed
performance metrics reflect long-term value creation
is starting to emerge (Young and O'Byrne 2001, The
Aspen Institute 2010, Deloitte 2010, PwC 2012, KPMG
2013, Towers Watson 2013). The debate is motivated
in large part by concern over the emphasis placed
on short-term performance outcomes and the
impact of such pressure on firm-level investment
decision-making and UK competitiveness more
generally. The Kay Review (2012), for example,
highlighted concern about the short-term orientation
of UK financial markets and corporate management,
while the High Pay Commission (2014) has expressed
concern that UK executives face short-term
decision-making pressure aimed at delivering quick
improvements in accounting returns rather than
improving underlying productivity and investing in the
long-term future of the company. As a result, the way
executive performance is measured and rewarded
is facing scrutiny from a range of financial market
stakeholders including the Department for Business,
Innovation and Skills (DBIS), the CFA Society of the UK
(CFA UK), the Association of British Insurers (ABI) and
the High Pay Commission, all of whom have expressed
doubt over the extent to which performance metrics
commonly used in executive compensation contracts
represent relevant and reliable measures of long-term
value creation.
This report comprises two parts. Part A synthesizes
the academic and professional evidence regarding the
structure of executive compensation arrangements,
with particular focus on the metrics used to link
executive pay to corporate performance. For the
purpose of our analysis, executives are defined
narrowly to include the Chief Executive Officer (CEO)
and other board-level members of the executive team
(e.g., the Finance Director). Part B presents empirical
results on executive compensation plan design and
links with value creation for a representative sample
of FTSE-100 companies with data for the period 2003
to 2013.
Notes:
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PART 1:
LITERATURE REVIEW AND CRITIQUE
We begin by reviewing the structure of executive pay
arrangements in the UK and the regulatory system
in which CEO pay is governed. Section 3 reviews
key theoretical insights concerning pay structures,
including the demand for performance-based
compensation in a traditional principal-agent setting,
the need for compensation arrangements that balance
the demand for short-term results against the need for
long-term value creation, the importance of aligning
executives’ and shareholders’ risk preferences, and
the use of relative performance evaluation. While
the majority of theoretical work in this area focuses
on agency problems between managers and
shareholders, section 4 reviews the small body of work
examining the link between executive compensation
plan design and capital structure.
Consistent with our focus on performance
measurement, section 5 reviews the properties of
a range of performance metrics including share
returns, cash flows, earnings, and economic profits.
Advantages and disadvantages associated with
each category are discussed. In section 6 we review
theory and evidence on the choice between alternative
performance metrics. Section 7 reviews evidence from
academic research and professional surveys regarding
the performance metrics to which CEO pay is linked.
A striking feature of the analysis is the dominance of
unsophisticated measures of periodic performance
such as earnings per share and total shareholder return
that (i) focus exclusively on returns to shareholders and
(ii) ignore the cost of capital.
A vast body of research highlights the dangers of
using inappropriate metrics to measure and reward
managerial performance. Section 8 synthesizes
evidence on the unintended consequences of
performance-related pay including investment
myopia, earnings manipulation, excessive risk
taking, and threats to organisational culture. This
section also presents a brief overview of research
examining the role of executive compensation in
the recent global financial crisis. Section 9 critiques
the prevailing approach to measuring and rewarding
executive performance, and seeks to understand
how such apparently flawed systems can persist
in equilibrium. Section 10 reviews the emerging
trend toward linking executive pay more closely to
corporate strategic priorities and key business drivers.
Section 11 concludes.
2 CONTEXT AND INSTITUTIONAL
SETTING
This section provides a brief overview of compensation
arrangements for CEOs and other senior executives
of the largest companies listed on the London Stock
Exchange, together with a brief summary of the
institutional and regulatory parameters in which
executive compensation is determined.
2.1 OVERVIEW OF PAY LEVELS AND COMPENSATION
STRUCTURE
Median total executive pay for FTSE 100 (250) CEOs
in 2013 including benefits but excluding pensions
was £3.2 (£1.3) million (KPMG 2013), with main board
members receiving approximately half as much (PwC
2012). Median total remuneration of FTSE 100 CEOs
(including pensions) rose from of £1m to £4.2m for the
period 1998-2010, equivalent to an average annual rise
of almost 14 percent (DBIS 2011). This rate of increase
outstripped growth in the FTSE 100 index, retail prices,
and average pay rises for other employees over the
comparable period (DBIS 2011, Farmer et al. 2013). 1
Annual CEO pay growth is positively correlated with firm
size: increases are highest among FTSE 100 companies,
followed by FTSE 250 companies, with Small Cap and
Alternative Investment Market companies reporting
the lowest increases in relative terms (DBIS 2011: 8).
Despite these large pay increases, UK CEOs earn less in
absolute terms than their U.S. counterparts even after
controlling for firm size, industry and other managerial
characteristics, although the gap diminishes
significantly after controlling for risk (Conyon et al.
2013, Conyon et al. 2011). Analysis of annual average
increases in CEO compensation reveals a plateauing
1 Murphy and Zábojník (2007) and Frydman (2006) examine the rise in CEO pay and provide general equilibrium models attributing increases to a growth in external hiring. Both
studies argue that demand for CEO talent has shifted from firm-specific skills (i.e., knowledge, contacts, and experience valuable only within the organization) to general managerial
human capital (i.e., human capital specific to CEO positions). A consequence of this shift is more external CEO hires, which in turn has increased equilibrium average CEO pay
relative to the pay of lower-level workers. Meanwhile, Kaplan and Rauh (2010) compare compensation increases among other talented and fortunate groups (financial service
sector employees, corporate lawyers, professional athletes and celebrities) to examine whether the growth in CEO pay reflects market forces. They conclude that growth in CEO pay
is not a sign of suboptimal contracting but rather a consequence of market forces that contribute to general wage inflation among high paid professionals.
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of pay growth from 2008 onwards (PwC 2012, KPMG
2013), consistent with attitudes and behaviours
changing as a consequence of increased scrutiny from
shareholders, Government, regulators, and the media
over recent years (PwC 2013).
The typical executive compensation package for FTSE
350 firms comprises the following four components
(PwC 2012, Conyon et al. 2013, KPMG 2013):
»» Salary: Annual salary represents the fixed component
of pay. The median CEO salary among FTSE 100 (250)
companies in 2013 was approximately £850,000
(£465,000), representing 26 (36) percent of total
pay inclusive of benefits (KPMG 2013). In response
to growing pressure to link pay with performance,
salary as a fraction of total compensation has
declined monotonically from approximately 40
percent in 1998 (DBIS 2011). However, despite
accounting for an increasingly small fraction of total
compensation, base salary remains a key element of
CEO pay because performance-related elements of
pay are typically defined as a multiple of base salary
(Murphy 1999).
»» Annual bonus: Bonus plans provide executives
with incentives to improve short-term corporate
performance. In a typical short-term bonus plan, the
executive is entitled to rewards that increase linearly
over a predefined performance range that is limited
by upper and lower bounds. The median maximum
bonus payable for FTSE 100 (250) CEOs in 2013 was
190 (125) percent of salary, while the median actual
bonus paid was 119 (93) percent of salary (KPMG
2013). An increasingly large number of UK companies
either require or permit a significant fraction of the
annual bonus (normally 50 percent) to be paid in
shares and deferred for several years. Where deferral
is voluntary, many companies award executives
additional matching shares subject to supplementary
performance conditions.
»» Equity incentives: Share-based incentives are
designed to encourage executives to focus on
long-term performance. The two most common forms
of equity incentives are share options and restricted
stock [also known variously as performance share
plans (PSPs) and long-term incentive plans (LTIPs)].
Both approaches link executive rewards to share
price performance over a defined range with
the aim of motivating CEOs to make value added
investments. Individual payoffs are deferred until
the end of a predefined vesting period (typically
three years), thereby further increasing executives’
longer-term focus. Share options were the dominant
form of share-based incentives until the mid-2000s
in the UK, after which point a series of regulatory
changes tipped the balance toward restricted stock.
Following recommendations in the Greenbury Report
(1995), both option and restricted stock vesting is
conditional on satisfying additional performance
conditions. In 2013, the median face value of share
option grants (restricted stock awards) for FTSE 100
CEOs was 250 (200) percent of salary (KPMG 2013).
Corresponding amounts for FTSE 250 CEOs were 205
and 150 percent, respectively.
»» Other forms of pay: Pensions and other benefits
(e.g., health care) comprise the residual elements
of executive compensation. Consistent with claims
that these elements present important sources of
compensation for executives (Frydman and Jenter
2010), DBIS (2011) report that pension payments
represent more than 10 percent of total annual
compensation for U.S. executives. Other benefits
tend to be immaterial as a fraction of total pay.
2.2 THE UK INSTITUTIONAL SETTING GOVERNING
EXECUTIVE COMPENSATION
The UK regulatory approach to executive compensation
revolves round a “comply or explain” philosophy that
allows firms to deviate from best practice guidelines
and prevailing norms when company-specific
conditions demand.
New disclosure regulations were introduced for
companies listed on the London Stock Exchange
with financial years ending on or after 30 September
2013. The structure of the new reporting regulation
involves the following three core elements: (i) an annual
statement from the Chairman of the remuneration
committee, (ii) an annual report on remuneration
including details of payments made to directors and
information on arrangements for the next financial
period, and (iii) a report detailing remuneration policy.
Compensation policy will also be subject to a binding
vote, applicable for financial years beginning on or
after 1 October 2014. The anticipated impact of the new
regulations remains unclear. A KPMG (2013) survey of
companies and shareholders conducted in June 2013
reported that 39 percent of respondents believed the
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regulations would make no difference, whereas the
majority of respondents to a PwC (2013) survey of 40
large firms concluded that the new regulations will have
an effect, at least in the short run.
Following the Walker Review (2009) and the application
of internationally agreed standards for remuneration
in the financial services sector, the Financial Services
Authority Remuneration Code for financial institutions
required provision to be made for claw-back where
performance turns out to have been miscalculated or
misstated. The UK Corporate Governance Code was
subsequently amended in 2010 to include the proposal
that “consideration is given to the use of provisions that
permit the company to reclaim variable components
in exceptional circumstances of misstatement or
misconduct”. Claw-backs are gaining in popularity
following shareholder best practice guidance advising
firms to consider their remuneration arrangements and
outcomes in the context of business risk. PwC (2012)
report that 50 (25) percent of FTSE 350 firms have
introduced or are considering introducing claw-backs
for annual rewards (long-term incentives) in the event
of any short-term misstatement of performance or
individual misconduct. 2
3 THEORETICAL FRAMEWORKS
This section reviews a variety of theoretical results
and insights on executive compensation including the
demand for compensation contracts that link pay to
firm performance, the need to align executives’ and
shareholders’ risk preferences, the need for incentive
mechanisms that balance short-term performance
pressures against long-term value creation, and the
role of relative performance evaluation.
3.1 AGENCY THEORY AND THE DEMAND FOR
PERFORMANCE-RELATED PAY
Mainstream academic research on executive
compensation has its roots in agency theory (Berle
and Means 1932, Ross 1973, Jensen and Meckling
1976, Holmstrom 1979 and 1982, Fama 1980, Lazear
and Rosen 1981, Grossman and Hart 1983). Within this
framework, compensation plans are designed to align
the interests of a risk-averse, self-interested agent (the
executive) with the interests of a risk neutral principal
(the owner). The resulting principal-agent models study
the trade-off between risk sharing and incentives in the
design of optimal compensation contracts. Effective
compensation plan design is predicted to play a central
role in value creation by resolving agency problems
associated with attracting, retaining, and motivating
professional managers (Murphy 1999).
The traditional set-up of principal-agent models
involves a risk-averse agent taking unobservable
actions that influence the statistical distribution over
observable performance measures. At the heart of
the theory is the notion of moral hazard, defined as
actions taken by the agent that are inconsistent with
the interests of the principal. Moral hazard problems
take many forms including prerequisite consumption,
shirking, and inappropriate risk taking behaviour.
The majority of moral hazard models typically assume
that the principal and agent have homogeneous
information at the inception of the contract but that
during the contracting period the principal is unable
to cost-effectively observe all the agent’s actions.
Unobservable actions combined with the agent’s risk
aversion results in a second best contracting solution
that involves the principal trading-off her desire to
provide appropriate incentives against the risk premium
that must be paid to the agent as compensation for
bearing the additional risk imposed by the contract.
The principal uses performance measures that are
observable ex post to design an ex ante efficient
incentive contract that will induce the agent to take
desired action(s). 3
The key insight emerging from early theoretical work
is that the optimal compensation scheme is a linear
function of observable measures of performance
such as profits or revenue (Holmstrom 1979 and 1982,
Grossman and Hart 1983, Holmstrom and Milgrom 1987).
This result forms the basis for more advanced models
that develop richer insights regarding contract design.
For example, Cao and Wang (2013) integrate search
theory into an agency framework to study executive
compensation in a market equilibrium. Their model
distinguishes idiosyncratic risk from systematic risk,
2 PwC (2012) report that the most popular means of implementing claw-back is to scale-back vesting.
3In the traditional property rights version of the agency literature, the principal’s desire to minimize agency problems drives the demand for compensation contracts. Jensen
and Meckling (1976) extend the traditional agency model by demonstrating that in a rational expectations setting shareholders do not lose, on average, from managerial perk
consumption and shirking (because shareholders rationally anticipate such behaviour and price protect). Instead, the full cost of expected non-value-maximizing behaviour is
born by management and as a consequence the demand for compensation contracts is driven by management as a monitoring and bonding mechanism aimed at convincing
the market to expect less perk consumption and shirking.
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assumes that an executive can choose to stay or quit
and search after privately observing an idiosyncratic
shock, and that the market equilibrium endogenizes
executives’ and firms’ outside options and captures
contracting externalities. Findings demonstrate that
the equilibrium sensitivity of the executive’s pay to
firm performance and the ratio of the executive’s total
compensation to firm value are positively (negatively)
correlated with idiosyncratic (systematic) risk.
Empirically, studies employing a range of different
approaches to measure the association between
executive pay and firm performance provide consistent
evidence that the pay-performance link appears weak
in both absolute terms and relative to the predictions
from principal-agent models (Jensen and Murphy
1990, Hall and Liebman 1998, Core and Guay 2002a,
Frydman and Jenter 2010). For example, using data
for 309 UK non-financial firms from the FTSE All Share
Index between 1995 and 2005, Ozkan (2011) concludes
that the pay-performance elasticity for UK executives
is low in both absolute and relative terms. In absolute
terms, a 10 percent increase in shareholder return
increases cash and total direct compensation by 0.75
percent and 0.95 percent, respectively. In relative
terms, these sensitivities are significantly lower than
comparable results documented for U.S. executives.
Further evidence suggests that the pay-performance
relationship is asymmetric, with executives being
rewarded for positive shocks and shielded from
negative shocks (Gaver and Gaver 1998, Bertand and
Mullainathan 2001).
3.2 ALIGNING RISK PREFERENCES
The standard agency model involves risk neutral
shareholders and risk averse executives. Incentivising
management to make investments consistent with
owners’ risk orientation is therefore a key objective of
effective compensation plan design. Share options
play a central role in aligning risk preferences. Options
introduce convexity in the executive payoff function:
executives are rewarded for share-price appreciation
above the exercise price but are not penalised when
share price falls below the exercise price. 4 Convexity
helps mitigate executive risk aversion insofar as the
value of the option to the holder is increasing in share
price volatility. The positive relationship between option
value and share price volatility creates incentives
for management to seek out risky projects. Knopf
et al. (2002) and Armstrong and Vashishtha (2012)
report evidence of a positive association between
executive option vegas (the sensitivity of share
option value to share price volatility) and executive
risk-taking behaviour.
However, the impact of share options is not limited to
volatility effects that promote risk taking behaviour.
Offsetting effects that reduce executives’ risk taking
incentives are also embedded in the standard share
option plan. In particular, the positive association
between option value and share price performance
when options are in the money, incentivises
management to eschew risky investments that
threaten share price performance in the short run
(Knopf et al. 2002, Ross 2004). Empirical evidence
confirms the presence of a negative association
between executive option portfolio deltas (the
sensitivity of option value to share price performance)
and executive risk taking behavior (Knopf et al. 2002,
Carpenter 2000).
Notwithstanding the central role that risk plays in
agency theory, Wiseman and Gomez-Mejia (1998)
contend that the standard formulation of risk in agency
models is too restrictive for several reasons. First, by
assuming principals (agents) to be risk neutral (risk
averse), the framework overlooks well established traits
such as risk-seeking or risk-loving behaviour (e.g., Piron
and Smith 1995). Second, agency models assume risk
preferences remain stable over time, which contradicts
behavioural decision theory (Kahneman and Tversky
1979). Third, agency theory treatments of risk and
performance are typically linear and recursive, whereas
insights from other literatures suggest more complex
associations between performance and individuals’ risk
choices (Kahneman and Tversky 1979).
In response, Wiseman and Gomez-Mejia (1998) develop
a behavioural agency framework that combines
insights from prospect theory (Kahneman and Tversky
1979) and agency theory to better explain executives’
choices with respect to strategic risk. The resulting
model suggests that executive risk taking varies across
different forms of monitoring, and that agents may
exhibit risk-seeking as well as risk-averse behaviour.
4 A
nnual bonus plans have similar characteristics. Bonus payments are a linear function of performance above the minimum performance threshold required to trigger payouts but
executives do not face “negative bonuses” as performance declines below the threshold level.
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Notable insights emerging from the model include: the
prediction that unexercised positively valued share
options create risk bearing for the agent leading to an
increase in executive risk aversion; the prediction that
high variable-pay targets increase executive risk taking
by increasing the probability that they will face a loss
decision context; and the proposition that reliance on
external market-based (internal accounting-based)
performance criteria increases the probability of a
loss (gain) decision context and therefore ultimately
increases (decreases) executive risk taking.
3.3 BALANCING LONG- AND SHORT-TERM
PERFORMANCE PRESSURES
Investment myopia occurs when executives take
actions (either opportunistically or in good faith) that
increase short-term performance at the expense of
long-term value creation. Examples of myopia include
cutting back on discretionary investment expenditures
such as research and development, advertising, and
employee training in effort to increase short-term
earnings performance at the expense of positive
future returns, sale-and-leaseback transactions that
increase accounting returns despite violating the net
present value (NPV) rule, failure to replace aging assets
that have been fully depreciated, disposing of positive
NPV assets to increase short-run earnings, and share
repurchases to increase short-run earnings per share
(Bens et al., 2002, Hribar et al. 2006, Young and Yang 2011).
Theory demonstrates that executive compensation
contracts can play an important role in mitigating
short-termism. For example, a large body of theoretical
work predicts that firms whose value is largely
determined by growth options are expected to use a
higher fraction of long-term incentives (e.g., stock options
and restricted stock) to counteract risk of managerial
myopia (Smith and Watts 1992, Bizjak et al. 1993, Gaver
and Gaver 1995). More recently, Edmans et al. (2012)
consider optimal compensation in a dynamic framework
where executives consume in each period, save
privately, and temporarily inflate returns. The resulting
optimal contract ensures the executive not only exerts
effort in the current period but also has sufficient equity
in future periods to sustain their effort and avoid myopia.
Findings provide guidance on how compensation
arrangements might be reformed to address problems
including short-termism (Kay Review 2012) and weak
incentives resulting from large stock price declines.
While the model developed by Edmans et al. (2012)
assumes the executive remains with the firm for a fixed
period, Bolton and Dewatripont (2005) demonstrate
how resignation risk significantly complicates
intertemporal risk-sharing arrangements because
the agent may leave the firm where she does not see
a high continuation wealth for herself. Conversely,
DeMarzo and Sannikov (2006) and DeMarzo and
Fishman (2007) develop risk-neutral models in which
contract termination provides an extra source of
incentives to the executive.
3.4 RELATIVE PERFORMANCE EVALUATION
Holmstrom (1982) introduces the notion of relative
performance evaluation (RPE). The key theoretical
insight from his model is that RPE is valuable where
one agent’s output provides information about another
agent’s state uncertainty (i.e., where uncertainties
faced by both executives are common). Incorporating
performance of agents exposed to similar uncertainties
into the compensation contract permits common
uncertainties to be filtered out, thereby shielding
executives from the effects of systematic risk and
avoiding owners overpaying for performance beyond
executives’ control. 5
Despite the theoretical appeal of RPE, many empirical
studies fail to provide consistent evidence supporting
its use (Antle and Smith 1986, Gibbons and Murphy
1990, Janakiraman et al. 1992, Aggarwal and Samwick
1999; Garvey and Milbourn 2003, 2006; Rajgopal
et al. 2006, Albuquerue 2009). One explanation for
these inconsistent findings is the indirect nature of
the empirical analyses, which often test for RPE by
examining the correlation between executive pay and
industry- or market-level measures of performance.
Accordingly, these studies ignore potentially important
elements associated with RPE contracts including
peer group composition, performance metrics, and
components of pay covered by RPE (Gong et al. 2011).
Recent research using mandated compensation
disclosures in the UK and U.S. suggest widespread use
of RPE provisions in executive compensation contracts
(Gong et al. 2011, Carter et al. 2009).
5Holmstrom’s (1982) analysis also implies that competition among agents has merit solely as a device to extract information optimally, and that competition per se is worthless.
As such, his findings cast doubt on the incremental incentive value of tournament schemes that tie compensation outcomes to an agent’s observable performance (Baiman and
Demski 1980; Lazear and Rosen 1981).
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4 EXECUTIVE COMPENSATION AND
CAPITAL STRUCTURE
The agency theory perspective on executive
compensation contract design emphasises conflicts
of interest between shareholders and senior
management. However, firms’ external claims are
not limited to equity. Jensen and Meckling (1976)
demonstrate that conditions resulting in moral hazard
and incomplete contracting between management and
shareholders also lead to moral hazard in contractual
relations between shareholders and other external
claimholders such as suppliers of debt capital.
However, despite apparently important linkages
between executive incentives and capital structure, the
majority of academic research examines these issues
separately. For example, seminal contributions by
Mirrlees (1976) and Holmstrom (1979) explore executive
compensation contract design in a principal-agent
framework that abstracts from capital structure
considerations, while agency models of capital
structure such as Jensen and Meckling (1976) and
Grossman and Hart (1983) do not consider managerial
compensation explicitly.
A small body of literature explores the link between
executive compensation plan design and capital
structure (Brander and Poitevin 1992, John and John
1993, Ortiz-Molina 2007). The primary insight from
this work is that optimal executive compensation
arrangements depend on not only the agency
relationship between shareholders and management
but also on conflicts of interest involving creditors.
Theory demonstrates that compensation contracts
cannot be structured to minimise the agency
costs of equity alone since there are agency
costs resulting from contractual relationships
with other external claimants including creditors.
Specifically, in the presence of risky debt, contractual
arrangements designed to minimise the agency
costs of equity by aligning managerial incentives
with shareholders’ interests can create incentives for
management to choose suboptimally risky investment
policies that benefit shareholders at the expense of
bondholders (Jensen and Meckling 1976). This problem,
which is often referred to as risk-shifting, creates
agency costs of debt finance because rational lenders
price debt securities taking into account managers
inferior risk choices.
Aligning executive compensation more closely with
total cash flows to the entity (rather than exclusively
with returns to shareholders) helps limit agency
costs of debt because rational lenders anticipate
executives’ superior risk choices and reduce their
required return. As residual claimants, shareholders
also gain from lower debt costs. An important
implication of this agency-costs-of-debt perspective
is that executive pay-performance sensitivity and
leverage are negatively correlated as entities with
risky debt surrender a degree of pay-performance
alignment with shareholders to reduce overall
agency costs and increase firm value. John and John
(1993) also use this insight to explain the apparent
inconsistency between the implications of formal
principal-agent models (which predict high sensitivity
of executive pay to observable performance) and
empirical evidence on executive compensation
realisations (which reveals surprisingly low
pay-performance sensitivities in practice).
An alternative (non-exclusive) explanation supporting
a negative relation between leverage and the
sensitivity of executive compensation to shareholder
returns is based on the monitoring benefits of debt.
The free cash flow hypothesis predicts that the
requirement to service debt payments reduces free
cash flow available to management and creates
powerful incentives for managers to focus on
value maximisation aimed at avoiding bankruptcy
costs (Grossman and Hart 1983, Jensen 1986). The
monitoring benefits associated with higher debt levels
may substitute for high-powered pay-performance
compensation incentives, leading to an equilibrium in
which highly levered firms are associated with lower
pay-performance sensitivity. Ortiz-Molina (2007) labels
this view the monitoring substitutes hypothesis.
Consistent with theory, several studies document that
the sensitivity of executive pay-to-shareholder wealth
is decreasing in leverage (Gilson and Vetsuypens
1993; Ortiz-Molina 2007). Ortiz-Molina (2007) seeks
to distinguish between the competing theoretical
arguments supporting this negative association. While
he finds some support for the monitoring substitutes
hypothesis, he concludes that the evidence is more
consistent with the agency-costs-of-debt explanation.
In particular, Ortiz-Molina (2007) finds the negative
association between leverage and pay-performance
sensitivity is especially pronounced for the option
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component of executive pay, where the incentives for
risk taking (and hence the agency costs of risk-shifting)
are particularly acute.
While the negative association between leverage
and pay-performance is consistent with an
agency-costs-of-debt interpretation, the evidence is
nevertheless indirect. As Conyon et al. (2013) stress,
although the risk-taking incentives associated with
debt are conceptually indisputable, no conclusive
evidence exists to suggest that executives in highly
leveraged firms actually take larger risks than their
counterparts in less leveraged firms. Furthermore,
Conyon et al. (2013) argue that any association
between risk taking and debt is unlikely to be
monotonic. Whereas executives in highly leveraged
firms might consider suboptimally large risks where
the downside cost is largely borne by debtholders,
they are also likely to avoid taking small risks that
trigger technical or actual covenant default (because
the costs associated with loss of control and financial
distress are likely to be large compared to the small
amount of costs passed on to debtholders.)
5 MEASURING PERIODIC
PERFORMANCE AND VALUE
CREATION
The property rights and principal-agent literatures
provide important insights regarding compensation
plan design and the importance of linking rewards to
observable outcomes. However, theory offers little
guidance regarding the practicalities of measuring
economic outcomes and the choice of specific metrics
against which managerial performance should be
judged and rewarded.
While finance theory dictates that investment decisions
should be made on the basis of discounted cash flows
and the NPV rule, periodic performance measurement
poses challenges for which economic theory
provides only limited guidance. Three fundamental
challenges exist with respect to periodic performance
measurement in a compensation contracting setting
(Feltham and Xie 1994). First, the actions and strategies
of the executive are not directly observable and as a
result she cannot be compensated directly for her input
into the firm. Second, observed outcomes are likely to
have been influenced by events from either internal or
external sources that lie outside the executive’s span
14 | www.cfauk.org
of control. Third, the full consequences of executives’
actions are not directly observable because the impact
of those actions can extend over several (many)
periods. This multi-period nature of performance
measurement serves to highlight the distinction
between measures of long-term value creation that
capture the full cash flow impact of investment
decisions versus periodic performance metrics that
capture a discrete slice of total performance.
At the heart of the performance measurement
problem is the need to discriminate between value
increasing actions and value destroying behaviour.
More generally, an effective performance measure
should capture whether management have generated
adequate returns on the resources at their disposal,
while also ensuring executives make appropriate
investment decisions (i.e., invest in additional resources
only when such investments produce an adequate
return and divest existing assets that are not yielding
an adequate return). Firms create value when they
generate economic profits, defined as returns that
meet or exceed the entity’s cost of capital. Economic
profits differ from accounting profits or raw market
returns because the latter metrics do not include
a periodic charge for the cost of invested capital.
Failure to benchmark periodic performance against
the opportunity cost of funds can lead to misleading
signals regarding the degree of value creation during
the measurement period.
The pool of available performance metrics includes
market-based information (e.g., stock price), cash
flows (e.g., operating cash flow and free cash flow),
accounting-based information (e.g., earnings and
return on investment ratios), value-based information
(e.g., economic profit), and non-financial information
(e.g., market share, consumer satisfaction). The
following sections review the properties of financial
performance measures. (A discussion of non-financial
and qualitative performance measures is presented in
section 6.)
5.1 MARKET-BASED METRICS
Share price performance is an obvious starting point
for assessing firm performance and value creation.
Although share price and total shareholder return
(TSR) may intuitively appear to be a necessary and
sufficient performance measure for publicly traded
firms to contract on for incentive purposes, Paul
(1992) highlights the problems of using share price
as the sole performance measure when designing
compensation contracts. First, share price tends to
overemphasise information about risky projects. 6
Second, share prices aggregate relevant information
inefficiently for compensation purposes. In particular,
share prices are forward-looking and therefore lead
to compensation for expected rather than delivered
performance (Venanzi 2010). Third, share price reflects
market-wide influences, thereby exposing executives
to factors beyond their control (Sloan 1993). While share
price captures factors that are unquestionably relevant
for firm value, many of these factors may have little to
do with executives’ contribution to value. Consistent
with this view, research demonstrates that the optimal
weights on information from a valuation perspective
are not necessarily the same as the optimal weights
for stewardship and incentive alignment (Gjesdal 1981,
Paul 1992). 7 Lambert (1993) further expands on this
insight by arguing that the task of firm valuation is not
equivalent to the task of evaluating an executive’s
contribution to firm value.
Further, equity market prices can deviate from
fundamentals for a variety of reasons ranging from
economic considerations such as limitations to
arbitrage (Shleifer and Vishny 1997) to behavioural
considerations including sentiment and “animal spirits”
(Akerlof and Shiller 2009). In addition, Sloan (1996, 2006)
demonstrates that markets are slower to incorporate
the full implications of periodic performance measures
than traditional efficiency views might suggest.
Management may also seek to engage in a range
of “financial shenanigans” (Schilit 2002) aimed at
presenting an excessively positive representation of
periodic performance and artificially inflating share
price in the short run. Although investors often see
through such behaviour, research demonstrates
that short-run mispricing can occur in response to
opportunistic reporting (Xie 2001).
5.2 CASH FLOW
Cash flows represent a theoretically appropriate
alternative to share price as a measure of performance.
Cash flows also enjoy strong intuitive support because
all investment returns ultimately boil down to cash
realisations and hence the view that “cash is king”.
Theory and practice highlights free cash flow (FCF) to
the firm as the appropriate cash flow measure from
a (long-term) valuation perspective, and therefore
using the same cash flows to assess short-term
performance appears a natural choice. Conceptually,
FCF represents residual cash flows generated by the
operating part of the business (i.e., cash earnings less
investment) that are paid to the financing component
of the entity (Penman 2001, Mauboussin 2006). More
formally, FCF is defined as cash earnings (sales plus
operating margin less cash taxes) minus investment
(change in working capital plus capital expenditures
plus net acquisitions), and as such represent cash
flows to all claimholders that provide finance to the
entity. Mauboussin (2006) presents a shorthand
approximation for FCF as:
FCF = NOPAT – Investment,
where NOPAT equals net operating profit after tax,
although the reconciliation is not so straightforward in
practice, particularly when investment takes the form
of intangible assets that show up as period expenses
rather than balance sheet assets.
Since FCF measures cash flows to all providers
finance, it represents a theoretically sound basis
for firm valuation. Consistent with other cash flow
measures, FCF is also considered to provide a reliable
indication of firm performance for several reasons.
First, the measure excludes allocations of historic costs
(accrual) and is therefore less susceptible than profit to
accounting manipulations or arbitrary accrual choices.
Second, FCF is less vulnerable than share price to the
impact of factors outside executives’ control.
Nevertheless, FCF suffers from the timing and
mismatching problems inherent in all cash flow
measures that create a periodic disconnect
between value-relevant actions and events, and the
corresponding cash inflows and outflows. Specifically,
cash flows do not necessarily follow economic events
in a timely manner, leading to a potentially weak link
with value creation when measured over short intervals
(e.g., 12 months). Dechow (1994) confirms that the
correlation between various cash flow metrics and
6Investors value information resolving uncertainty associated with risky projects. As such, investors’ preference in processing information is likely to distort share price as a
performance measure, even assuming the efficient market hypothesis holds [because share prices are noisy and fluctuate around a true (intrinsic) value].
7In particular, investors care about the extent to which a performance measure resolves uncertainty about the firm’s ultimate payoff, whereas from a contracting perspective the
principal is interested in degree to which the performance measure captures the agent’s unobservable effort.
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changes in firm value (share price) weakens as the
performance window narrows.
5.3 ACCOUNTING EARNINGS
Profit evolved as a solution to the timing and
mismatching problems inherent in cash flow. Earnings
adjust cash flows (through the accrual process) in
an effort to recognise the impact of economic events
occurring during the reporting period:
Earnings = Cash flow + Net accounting accruals
A range of different earnings metrics are available
depending on the level of aggregation required (e.g.,
the degree to which transitory items are included) and
whether periodic performance is being assessed from
an entity or equity perspective. 8
An extensive body of academic research demonstrates
that, on average, reported earnings are more highly
correlated with quarterly and annual changes in value
(measured using share returns) than periodic cash
flow, and better able to predict future operating cash
flows. [See Dechow (1994) and Dechow and Schrand
(2004) for evidence and further discussion.] In addition,
compared with share prices, accounting numbers are
less influenced by factors beyond managers’ control.
Accounting numbers therefore have the potential to
shield managers from the effects of uncontrollable
factors that affect share price (Sloan 1993).
Despite these benefits, accounting earnings are
characterised by several important weaknesses. First,
short-term earnings growth is imperfectly correlated
with long-term value creation. While the importance
attributed by investors to EPS leads many to conclude
that EPS growth dictates value, the fact that earnings
fail to explicitly account for capital intensity means
that two firms can report identical EPS growth rates
and yet if they have different return on invested
capital, they will naturally attract different valuations.
Mauboussin (2006) summarises the link between
earnings growth, return on capital, and value creation.
Earnings growth has a positive impact on value when
the firm’s return on capital exceeds its cost of capital.
In such circumstances, earnings growth and value
creation are aligned: rewarding earnings growth is
consistent with rewarding value generation. In contrast,
earnings growth has no effect on value where the
firm’s return on capital equals its cost of capital; and
for firms whose return on capital is lower than the cost
of funds, positive earnings growth serves to destroy
value. These two latter situations highlight the potential
folly of relying on (incentivising) earnings growth: in
extreme cases, emphasising earnings growth can lead
to overinvestment and value reduction (Brealey et al.
2008).
Second, earnings are subject to inaccuracy and
subjectivity as a result of the accrual process.
Research demonstrates that earnings quality (i.e., the
ability to forecast future performance or estimated
value) is decreasing in the relative magnitude of the
accrual component. High accruals provide executives
with more opportunities to manipulate reported results,
particularly in response to compensation-related
incentives (Healy 1985, Holthausen et al. 1995,
Bergstrasser and Philiponn 2006). (See section 8.2
for a more detailed treatment of the literature linked
earnings management with compensation plan
design.) Third, accounting typically treats investment
in intangible assets and growth options as a period
expense, thereby increasing the risk of managers
cutting value-increasing investment spending to boost
short-term accounting earnings (Dechow and Sloan
1991, Bushee 1998, Graham et al. 2005).
In recognition of the problems associated with using
profit to measure periodic performance in situations
where management can influence the asset base
(Otley et al. 1990), earnings are often scaled by
a measure of invested capital to produce return
investment metrics such as return on assets (ROA)
and return on equity (ROE). Unfortunately, because
short-term improvements in such ratios can be
achieved through reductions in the denominator as well
as increases in the numerator, return on investment
ratios can incentivise managers to make dysfunctional
investment decisions such as rejecting positive NPV
projects whose return is lower than the prevailing
accounting return, retaining (depreciated) non-current
assets beyond their optimal useful economic life,
engaging in suboptimal off-balance sheet financing
arrangements such as sale-and-leaseback
transactions, and in the case of ROE undertaking
8Earnings derived using generally accepted accounting principles (GAAP) include transitory and non-cash items that have few implications for future performance. Management
and equity analysts often rely on non-GAAP earnings definitions (also known as pro forma or “street” earnings) that adjust reported net income for the effect of transitory items and
certain non-cash adjustments. On average, these non-GAAP earnings metrics are more informative about periodic performance than the corresponding GAAP measure. However,
adjustments to GAAP earnings made by management have also been linked with manipulation. [See Young (2014) for a review of the literature on non-GAAP earnings.]
16 | www.cfauk.org
decretive debt-financed stock repurchases. More
generally, accounting-based return on investment
metrics can create incentives for managers to forego
strategic activities that are value-increasing in the
medium- to long-term in favour of reporting higher
accounting performance in the short-term. 9
5.4 ECONOMIC PROFIT AND VALUE-BASED METRICS
A serious weakness of accounting profit is its failure to
benchmark performance against the cost of invested
capital. As highlighted above, maximising periodic
profit or earnings growth is not necessarily consistent
with value maximisation when capital costs are
omitted. From an economic perspective, value creation
occurs when the return generated by an entity meets
or exceeds the cost of raising funds from external
capital providers. Failure to consider the cost of capital
results in periodic performance measures that do not
properly capture whether management have generated
adequate returns on the recourses at their disposal;
it can also create incentives for management to take
investment decisions that are inconsistent with the net
present value rule.
recognising the finite economic life of depreciating
assets and the residual value of non-depreciating
assets such as land and working capital.
Stern Stewart’s EVA© represents a special case of
the more general residual income concept (Solomons
1965, Peasnell 1982). Broadly defined, residual income
is equal to periodic return less a charge for the cost of
capital invested in the business. Residual income (RI)
measured from an entity perspective is defined as net
operating profit after tax (NOPAT) minus a charge for all
capital invested in the business:
RI = NOPAT – (WACC * IC),
A series of value-based metrics have been proposed
to overcome this weakness. Such metrics explicitly
acknowledge the costs of both equity and debt
finance and therefore incorporate financing risk-return
trade-offs into the performance measurement problem
(Venanzi 2010). Common value-based performance
measures include Stern Stewart’s Economic Value
Added (EVA©) metric and Boston Consulting Group/
HOLT Value Associates’ Cash Flow Return on Investment
(CFROI) metric. These and related value-based metrics
have their roots in DCF technology and in particular the
need to compare periodic returns against the cost of
capital. Not surprisingly given their common theoretical
base, it can be shown that these metrics yield the
same NPV when consistent assumptions are applied
(Myers 1996).
where NOPAT equals earnings before interest and
taxes (EBIT) plus interest income, minus taxes and
the estimated tax shield on interest payments, WACC
is an estimate of the firm’s weighted average cost
of capital, and IC is invested capital, measured as
assets (net of depreciation) invested in going-concern
operating activities (or equivalently, contributed and
retained debt plus equity capital at the beginning
of the period). 10 Intuitively, RI is an estimate of true
economic profit: the amount by which earnings
exceed or fall short of the required minimum rate of
return that providers of finance could generate by
investing in securities of comparable risk. Positive
RI indicates a return in excess of the cost of capital
used to generate the return (i.e., value creation),
while negative RI indicates that the periodic return is
insufficient to cover the cost of invested funds (i.e.,
value destruction). Theory demonstrates that RI leads
to performance and investment signals that are more
consistent with the NPV rule than periodic profit or
standard return on investment metrics such as ROA
and ROE. Nevertheless, even single-period RI is unable
to guarantee performance and investment signals that
are always fully consistent with the NPV rule (unless
combined with annuity depreciation and constant
annual cash flows) (Otley et al. 1990). 11
CFROI compares an entity’s (inflation-adjusted) cash
flow to all capital owners with the (inflation-adjusted)
made by the capital owners to generate those flows.
This ratio of gross cash flows to gross investment
is then translated into an internal rate of return by
Stern Stewart’s EVAÓ metric is an example of how a
measure based on the RI concept can be used as part
of a value-based approach to managing executive
performance. EVAÓ differs from standard RI in equation
(3) as a result of adjustments to published accounting
9This weakness is not unique to earnings; it applies to any periodic performance metric that is scaled by a measure of firm size over which management is able to exercise a
degree of control. However, since scaling is more common for earnings-based measures of performance the problem tends to be more acute in this context
10 From an equity perspective, residual income is defined as net income for shareholders less the product of shareholders’ equity and the cost of equity.
11Variable annual cash flows creates the possibility of management favouring projects with high RIs in the early years but yielding lower NPVs than competing projects where a
larger fraction of RI is delivered in later years. In such cases, discounting RIs over the life of the project is the only to ensure investment decisions consistent with the NPV rule.
www.cfauk.org | 17
numbers made by Stern Stewart that are designed to:
(1) produce a performance measure that is closer to
cash flows, and therefore less subject to the distortions
of accrual accounting; (2) remove the arbitrary
distinction between investments in tangible assets that
are capitalised, and intangible assets that are required
to be written off as incurred; (3) prevent amortisation,
or write-off, of goodwill; (4) bring off-balance sheet debt
(e.g., operating leases) back on the balance sheets; and
(5) correct biases caused by accounting depreciation.12
EVAÓ approaches to performance measurement and
compensation plan design have been adopted by a
significant number of public companies in countries
such as Australia, Brazil, Canada, France, Germany,
Mexico, Turkey, the UK, and the U.S. (Worthington and
West 2001).
Research tests whether residual income and its
cousins such as EVAÓ display higher correlations with
value creation (proxied by share returns) relative to
alternative measures of accounting profit and return.
Results are mixed: while evidence supporting the
incremental value relevance of residual income has
been documented, the magnitude of the improvement
is relatively small and the evidence is not robust
across different samples and time periods (Stewart
1991; O’Byrne 1996, 1999; Biddle et al. 1997; Stark and
Thomas 1998). More direct evidence regarding the
benefits of using residual income-style measures of
periodic performance is reported by Wallace (1996)
using a sample of firms that implement RI-based
reward systems.
5.5 SUMMARY
The primary insight emerging from the review of
accounting-based metrics presented in sections
5.3 and 5.4 is that no practically acceptable profit
performance measure exists that will guarantee
consistency with the results given by DCF techniques
and the NPV rule. Central to this misalignment is the
fact that long-run models of planning and value
creation use cash flows whereas short-term
profit measures are based on accrual accounting
concepts. While accrual accounting provides useful
measures of period performance on average,
over-reliance on these metrics can lead to executives
to make investment decisions that are not in the firm’s
best long-run interests.
6 CHOOSING FROM THE MENU
OF AVAILABLE PERFORMANCE
MEASURES
In the absence of a first-best measure of periodic
performance, Boards and compensation consultants
are forced to adopt metrics that yield the most
efficient second-best solution to the problem of
measuring and incentivising executive performance.
This section reviews theory and evidence concerning
the choice between alternative performance metrics
for compensation contracting purposes. We begin
by explaining why share price does not represent a
sufficient statistic on which to determine executive
pay. Then we review theory and evidence concerning
the optimal weights assigned to multiple performance
measures used in combination.
6.1 THE ROLE OF SHARE PRICE IN COMPENSATION
CONTRACTS
The problem of which performance measure (or set
of measures) to use in the optimal compensation
contract on has been studied widely in principal-agent
literature. Intuitively, one might think that if the
shareholders’ goal is to maximise (long run) firm value
and share price is observable then the solution to
the incentive problem is straightforward: the optimal
contract links managerial compensation to stock price
performance. Casual empiricism, however, reveals that
executive compensation contracts regularly utilise
non-priced-based performance measures, suggesting
that exclusive reliance on market-based measures
(where they exist) does not provide an optimal solution
to the contracting problem. Holmstrom’s (1979) provides
the key insight to help resolve this apparent paradox in
the form of his informativeness principal.
Holmstrom (1979) argues that payments to
managers are based on stock price not because
shareholders desire higher stock prices but because
price realisations provide information useful in
determining which actions management took (given
that managerial actions are not directly observable
12Stern Stewart makes as many as 164 adjustments on residual income to arrive at EVA. See Stewart (1991), Rennie (1997), Young (1999), and Worthington and West (2001) for further
details on Stern Stewart’s list of adjustments. Notwithstanding the large number of adjustments that are available, Young and O’Byrne (2001) find it hard to find an EVA© user
making more than 15 adjustments. Further, they argue that the number of adjustments employed by firms is declining, and attribute part of the decline to two factors: managers’
reluctance to deviate from GAAP numbers, and the limited impact of adjustments on reported profits. Chen and Dodd (1997: 331) argue that it is possible to gain most of the practical
benefits associated with EVA© metric by using the standard residual income metric.
18 | www.cfauk.org
by the principal). The insight is profound because it
opens the door to the use of other (non-priced-based)
performance metrics that also provide information on
whether management took the desired action (Banker
and Datar 1989, Feltham and Xie 1994). Holmstrom’s
(1979) formulation therefore provides a clear role for
the use of additional performance measures (such as
accounting-based metrics) in the incentive contract.
Indeed, where these other measures constitute a
sufficient statistic for assessing managerial actions,
share-based measures need not be used at all.
6.2 DETERMINING THE OPTIMAL WEIGHTS FOR
CONTRACTS WITH MULTIPLE PERFORMANCE
MEASURES
While Holmstrom’s (1979) analysis motivates the
use of performance metrics beyond share price,
it provides few insights into the relative weights
placed on multiple performance measures in the
optimal linear incentive contract. Subsequent
research provides only general guidance on how
individual metrics should be combined to form an
overall assessment of performance. The majority of
theoretical models exploring the relative weighting of
alternative performance measures typically consider
two generic categories of metric: market-based
measures (such as share price and total shareholder
return) and single-period products of the accounting
system (such as net income, operating profit, FCF, and
residual income). Theoretical insights concerning the
way market-based measures and accounting-based
measures are combined to deliver effective contracting
solutions are provided by Banker and Datar (1989),
Bushman and Indjejikian (1993), Kim and Suh (1993),
Lambert (1993), and Sloan (1993) among others. These
models simplify the problem to the choice between
share price and accounting earnings, where the
latter can be any aggregation of periodic income
and expenses.
Research demonstrates that for a contract based on
two performance measures such as stock price (P)
and accounting earnings (E), the incentive weight on
E relative to P is the product of (i) the sensitivity of
each measure to manager’s actions and (ii) precision
of each performance metric. All else equal, the weight
on P (E) in the optimal contract increases both in P’s
(E’s) sensitivity to managerial effort and the precision
with which each measure captures managerial effort
(Banker and Datar 1989, Kim and Suh 1993, Lambert
1993). Performance measures that are insensitive to
managerial effort or that capture effort with significant
measurement error (high noise) will be assigned
low weight in the optimal contract. Nevertheless,
even performance measures that are assigned low
weights are useful under the informativeness principle
because they help to avoid imposing unnecessary
(costly) risk on the executive by filtering noise from
other contracted performance metrics. Motivated by
the prevalent use of accounting numbers in executive
compensation contracts, Sloan (1993) presents
empirical support for the prediction that earnings are
more sensitive to firm-specific changes in value than to
market-wide changes in value and therefore help shield
executives from uncontrollable risks. 13
Insights summarised above apply to a single task
setting (i.e., firm value is a function of managerial
effort choice and the marginal product of managerial
effort). Although informative, this setting is limited
because it is widely acknowledged that in practice
the key contacting problem for senior executives
is not incentivising them to work hard. Instead, the
primary contracting problem typically revolves round
the best way to incentivise managers to allocate
effort appropriately across different tasks (i.e., how
to incentivise managers to choose the correct mix
of actions and decisions that increases shareholder
value). The solution to this problem also highlights the
need for multiple performance measures. In a setting
where fundamental value (V) is unobservable and only
stock price (P) is contractible, theory demonstrates that
a compensation contract relying exclusively on P leads
the executive to misallocate effort between activities
relative to the optimal contracting weights. The solution
to this misallocation problem involves rebalancing
incentives by including additional performance
measures in the contract (Bushman and Indjejikian
1993). All else equal, theory predicts that in such
multi-task settings, the incentive weight on a given
performance measure decreases (relative to the weight
on alternative measures) as the importance to value
of activities not captured by the metric increases. In
particular, Bushman and Indjejikian (1993) demonstrate
13In practice, however, use of unfiltered stock price and the resulting excess weighting on market measures may be optimal because it allows shareholders to share part of their
trading risks with the manager (Kim and Suh 1993).
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that in the case where accounting metrics reflect only
a subset of private information that investors impound
into share price, measures such as earnings serve
to filter uncontrollable factors and achieve a better
balance of incentives across managerial activities.
Feltham and Xie (1994) shed further light on the
properties of performance measures. In addition to
notions of sensitivity and noisiness, they introduce
the idea of congruence, which is best interpreted as a
refined version of sensitivity. While sensitivity focuses
on the association between executives’ actions and
a given performance measure, congruence links a
performance measure directly with the principal’s
payoff. Rather than being evaluated exclusively by its
correlation with executives’ actions, the performance
measure is also assessed according to its alignment
with the principal’s interest. Feltham and Xie (1994)
demonstrate that a contract based on a non-congruent
performance measure induces suboptimal effort
allocation across tasks (effort direction), whereas
performance measure noise results in suboptimal effort
intensity on a given task. Considering the potential
trade-off between congruence and noisiness, the
model demonstrates that multiple performance metrics
should be used jointly to offset limitations associated
with individual metrics.
Building on the notion of congruence, several studies
highlight how performance measures are subject to
distortion (Baker 2000, Bushman et al. 2000, Baker
2002). Distortion occurs when metrics incentivise
managers to take actions that are not congruent
with corporate goals. While distortion and noise are
separate properties in principle, they have similar
effects on performance measure efficacy (Bouwens
and Lent 2006). In particular, both properties are
expected to create weaker incentives resulting in lower
effort levels. Baker (2002) argues that a performance
measure’s usefulness in compensation contract
design depends on its distortion and noise: the more
distorted and the noisier (riskier) the measure, the lower
its usefulness in a compensation contract context.
Furthermore, given the scarcity of performance
measures characterised by low levels of distortion and
noise, contracts typically involve trading off the costs
of high distortion versus high noise.
Inspection of executives’ actual compensation
contracts reveals widespread use of individual
20 | www.cfauk.org
performance objectives such as implementing
restructuring and cost cutting programmes, improving
workforce safety, etc. Bushman et al. (1996) highlight
the use of individual performance evaluation (IPE) in
CEO annual incentive plans and the implication that IPE
is useful in providing incremental information beyond
accounting and market performance measures. Based
on the view that accounting earnings and stock price
collectively may fail to capture information concerning
key executive actions, Bushman et al. (1996) identify
firms where traditional accounting and market metrics
are likely to yield noisy measures of performance, and
test whether IPE is more prevalent in such settings.
Consistent with predictions, results show that
reliance on IPE increases with the length of product
development and product life cycle, level of information
asymmetry between managers and investors, CEO
tenure, and firm size (complexity).
Consistent with predictions from agency theory,
UK-listed firms pre-specify executive goals over
multiple performance metrics (Conyon et al. 2000,
Pass et al. 2000, Young and Yang 2011, PwC 2012, KPMG
2013). From the menu of available performance metrics,
research reveals that income measures (e.g., EPS, net
income growth, and EBIT), accounting returns (e.g.,
ROE and ROA) and market-based metrics such as TSR
dominate. For example, KPMG (2013) report that 60 (57)
percent of FTSE 350 companies’ performance share
plans use TSR (EPS) either separately or in conjunction
with other measures. Meanwhile, the most common
combination of performance measures for FTSE 350
CEOs consists of either a two-way mix of financial
and personal metrics or a three-way combination of
financial, non-financial, and personal metrics, with FTSE
100 (250) firms preferring the three-way (two-way) mix
(PwC 2012).
Kaplan and Norton (1992) formalise the idea of
supplementing accounting- and market-based metrics
with qualitative and non-financial performance
measures. They develop a balanced scorecard
approach in which operational measures (e.g.,
customer satisfaction, internal processes, and the
organisation’s ability to learn and improve) are used in
collaboration with traditional financial measures. While
financial measures present information on actions
already taken, operational measures add incremental
information concerning strategy implementation and
activities that drive future performance. Ittner et al.
(1997) examine the factors associated non-financial
measure usage and find that firms following an
innovation-oriented “prospector” strategy are more
likely than firms following a cost leader or “defender”
strategy to place greater weight on non-financial
metrics. Firms following quality-oriented strategies also
place more weight on non-financial measures.
Studies reveal that performance measure choice
varies significantly across individual compensation
components. For annual bonus plans and
performance-vesting share options, income measures
tend to dominate (Young and Yang 2011, PwC 2012).
Profitability measures such as operating profit, profit
before tax, earnings before interest and tax (EBIT)
are used by approximately 50 percent of firms for
determining bonus payments, with EPS the next most
popular metric (26 percent) (Young and Yang 2011).
Other accounting metrics such as return on capital and
residual income are used by fewer than five percent of
firms. Meanwhile, EPS is used in the majority of firms’
performance-vesting option plans.
7 EVIDENCE ON PERFORMANCE
MEASURE SELECTION
This section reviews evidence from the academic and
professional literatures on the choice of performance
measures in executive compensation contracts.
Early research on this topic was limited by a lack of
transparency. However, improvements in disclosure
requirements mean that clearer insights regarding
the performance metrics that drive executive pay are
now possible.
While TSR is rarely used in annual cash-based bonus
plans and performance-vesting share options, it is the
most widely used measure in LTIPs: 18 (20) percent
of FTSE 100 (250) firms use it in isolation, 27 (38)
percent in conjunction with EPS, and 28 (10) percent in
conjunction with other metrics (PwC 2012). 14 TSR is also
used as frequently as EPS in share matching deferred
annual bonus plans (either on its own or in conjunction
with other metrics).
Non-financial metrics (e.g., customer satisfaction,
market share, employee safety, sustainability
targets, etc.) and personal objectives are also used
to determine executive pay. While traditionally these
metrics were limited largely to bonus plans (Young
and Yang 2011), recent survey results suggest their
popularity is growing in LTIPs. (See section 9 for further
discussion.)
Similar patterns to those documented above for
UK-listed firms are also evident among their U.S.
counterparts. De Angelis and Grinstein (2014) find that
of the total estimated value of performance-based
awards for the average S&P 500 firm, 79 percent is
based on accounting-performance measures, 13
percent is based on share-based measures, and 8
percent is based on non-financial measures. Also
consistent with UK results, De Angelis and Grinstein
(2014) report that 56 percent of the estimated value
of accounting-based performance awards are linked
with income measures such as EPS, 17 percent with
accounting return measures, and 12 percent with
sales measures. Evidence from academic studies is
consistent with survey evidence that also highlights
the dominance of EPS and TSR (e.g., PwC 2009, Towers
Watson 2013).
Commonly used measures of performance such as
EPS and TSR do not ensure perfect alignment with
long-term value maximisation. Investment decisions
taken by executives with the aim of achieving (EPS
and or TSR) performance targets need not lead to
corresponding improvements in firm value; because
maximizing these metrics can be done in
undesirable ways.
Indeed, motivating executives to turn in good measures
of performance can cause more problems than it
solves. The primary incentivisation problem is not about
encouraging executives to achieve specified results:
it is more about ensuring results are achieved in the
appropriate manner. The following section discusses
the negative consequences of performance-related
compensation arrangements.
8 THE UNINTENDED CONSEQUENCES
OF PERFORMANCE-RELATED
COMPENSATION
This section examines the problems of linking
executive pay to imperfect measures of corporate
performance. We begin by highlighting the behavioural
consequences associated with measuring and
rewarding performance. Evidence on a range of
14 KPMG (2013) report that 60 (40) percent of new LTIPs introduced by FTSE 350 firms in 2013 used TSR (EPS) either on its own in conjunction with other performance metrics.
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unintended consequences are reviewed including
short-termism, manipulation, excessive risk taking,
and threats to corporate culture. We conclude with a
brief summary of the debate surrounding the role that
executive compensation arrangements played in the
recent global financial crisis.
8.1. WHAT YOU PAY IS WHAT YOU GET
A large body of research in the psychology and
management literatures clearly demonstrates that
the existence of a particular performance measure
together with appropriate rewards will motivate
actions that improve the measure. Of course, this is
precisely the reason why performance management
systems play such an important role in overcoming
agency problems. Wallace (1996) highlights the
positive aspects of this effect in the context of residual
income-based compensation plans that create
incentives to increase operating efficiency, asset
utilisation, and payouts of excess cash to shareholders.
However, the powerful behavioural effects that
performance-related pay can have on individuals’
actions is a double-edged sword insofar as it can lead
to fixation on achieving narrowly-defined performance
outcomes that are at odds with long-term value
creation. The organisation and management literatures
are littered with examples of what Kerr (1975) refers
to as the folly of rewarding A but hoping for B. The
message from a vast body of literature in economics,
management, strategy, organisations, finance, and
accounting is unambiguous: what you pay is what
you get. Considerable care is therefore required to
ensure performance metrics incentivise appropriate
value-increasing behaviour rather than promoting
dysfunctional, value-decreasing actions. Examples of
dysfunctional behaviour leading to value-destroying
decisions caused by performance metrics that do not
align perfectly with long-run organisational objectives
include investment myopia, earnings manipulation and
gaming, excessive risk taking, and threats to corporate
culture and reputation. Choosing a performance metric
(or set of metrics) that incentivises preferred outcomes
and minimises the risk of dysfunctional behaviour
is critical to the effectiveness of reward systems in
general and executive compensation arrangements in
particular (because executives control more financial
resources and therefore face greater opportunities to
damage value through poorly aligned decisions).
22 | www.cfauk.org
8.2 INVESTMENT MYOPIA
Stein (1989) shows analytically how managerial
myopia can exist as an equilibrium outcome even
when capital markets are efficient. Short-termism is
widely acknowledged as representing a significant
threat to overall UK competitiveness (Marsh 1990,
CFA Institute 2006, Kay Review 2012, CFA UK 2011a).
Research supports claims of myopic corporate
decision-making generally and highlights the role that
compensation-related incentives play in encouraging
managerial short-termism. Graham et al. (2005)
survey 400 senior U.S. financial executives and find
that 80 percent of respondents acknowledge they
would decrease value-creating spending on research
and development (R&D), advertising, maintenance
and hiring to report positive short-term earnings
growth. Consistent such claims, archival research
demonstrates that management are more likely to
reduce discretionary investment expenditure when
doing so helps their firm achieve quarterly or annual
earnings expectations (Bushee 1998, Osma-Garcia and
Young 2009).
Research examining the impact of compensation
plan design on investment decision-making highlights
the importance of performance metric choice. On
the positive side, Wallace (1996) demonstrates how
adoption of residual income-based bonus plans
designed to motivate long term value creation leads
executives to dispose of underperforming assets that
had been generating positive earnings but not covering
the cost of capital. In contrast, Dechow and Sloan
(1991) study investment decisions by CEOs in the years
immediately prior to retirement and find that retirees
cut spending on R&D in their last years of office in an
effort to maximise short-run compensation linked to
earnings performance. Recent research examining
the causes of the financial crisis also suggests a link
between CEO compensation arrangements and myopic
decision making (Cai et al. 2010, Erkens et al. 2012). (See
section 8.5 for a more complete summary of the role of
executive compensation in financial crisis.)
8.3 GAMING
Murphy (2012) concludes that any form of incentive
compensation introduces the risk that managers will
opportunistically manipulate performance outcomes
to achieve favourable compensation payouts. 15
Manipulation may take the form of accounting trickery
(earnings management) or suboptimal decision-making
with respect to operating activities and investments
(real earnings management). Empirical evidence
supports the view that managers use their accounting
and investment discretion to deliver performance
outcomes that maximise short-term compensation
payouts (Healy 1985, Dechow and Sloan 1991,
Bergstresser and Philippon 2006, Burns and Kedia
2006, Johnson et al. 2009). The evidence confirms the
prediction from behavioural psychology that individuals
focus effort on actions that ensure favourable
outcomes in relation to the measure(s) against which
their performance is assessed: what you pay is what
you get.
Non-linearities in bonus plan structures such as caps
and floors represent a particularly egregious source
of manipulative behaviour (Healy 1985, Holthausen
et al. 1995, Jensen 2003). Long-term compensation
awards are granted to mitigate manipulation problems
associated with bonus plans and short-term
performance measures. However, equity incentives
also create incentives for gaming aimed at boosting the
value of share-based rewards either by manipulating
earnings (Bergstresser and Philippon 2006, Burns
and Kedia 2006, Gao and Shrieves 2002, Cheng and
Warfield 2005, Efendi et al. 2007, Peng and Röell 2008,
Johnson et al. 2009) or by manipulating the grant date
timing of options (Yermack 1997, Aboody and Kasznik
2000, Heron and Lie 2009, Bebchuk et al. 2010). In
contrast, Armstrong et al. (2010) report that CEOs with
large stock option and equity holdings are less likely to
manipulate published accounting results, consistent
with the view that equity incentives help to reduce
agency problems.
Executives may also manipulate other aspects
of their compensation arrangements including
performance standards, risk, peer groups, and
disclosures. For example, executives may seek to
avoid target ratcheting (Holthausen et al. 1995) by
reining-in reported results in an attempt to prevent
high contemporaneous performance establishing
a benchmark against which future performance is
assessed. Meanwhile, Faulkender and Yang (2010)
argue executives have multiple ways to hedge against
the risks of exposure in high-powered contracts and
it is hard to tell whether managers do it to efficiently
rebalance their portfolios when firm-specific holdings
are excessive or just to remove appropriate incentives.
Core et al. (2003) report that derivatives are often used
to hedge firm-specific risk by managers.
Where executive compensation contracts contain a
significant RPE component, management can affect
payouts by exercising their discretion over the choice
of peer group constituents. All else equal, selecting peer
groups characterised by weaker performance will lead
to higher payouts under RPE. Carter et al. (2009) use UK
data and find limited evidence supporting opportunism
with respect to peer selection. Peer groups are also
relevant in terms of compensation benchmarking,
creating incentives to opportunistically select firms
where CEOs are highly paid (Faulkender and Yang 2010,
Bizjak et al. 2011). Albuquerque et al. (2013) on the other
hand argue that choice of highly paid peers represents
a reward for unobservable CEO talent.
8.4 EXCESSIVE RISK TAKING
There are two ways incentive compensation can create
incentives for risk taking. The first way is through
asymmetries in rewards for good performance and
penalties for failure (Conyon et al. 2013). Linear payout
structures ensure that executive wealth increases
and decreases symmetrically with changes in firm
value. Most pay-performance structures, however,
involve significant non-linearities such as convexity
in the share option payout function: executives
receive rewards for upside risk but are shielded from
the negative consequences of downside risk. 16 A
consequence of such arrangements is that executives
can face strong incentives to take excessive risks with
shareholders’ capital when their compensation payoffs
are out of the money. Essentially, management face
a “double or quits” gamble where they benefit from
upside gains and are insulated from downside losses.
Linearizing the payout function provides an obvious
solution to the problem of excessive risk taking
because executives take less risk when they face
symmetric consequences. However, several factors
mitigate against such a solution. First, managerial
15 For models of performance manipulation, see Bolton et al. (2006), Goldman and Slezak (2006), and Benmelech et al. (2010).:
16 Such claims reward executives for share-price appreciation above the exercise price but do not penalize them when share price falls below the exercise price. Accordingly,
executives with options close to expiration and that are out of the money have strong incentives to gamble. Annual bonus plans have similar characteristics. Bonus payments are a
linear function of performance above the minimum performance threshold required to trigger payouts but executives do not face “negative bonuses” as performance declines below
the threshold level. As a result, executives just below the threshold level face particularly powerful gaming and risk taking incentives.
www.cfauk.org | 23
risk aversion (or at least lower risk tolerance relative
to shareholders) provides a partial explanation for
convex payout structures. Second, negative bonuses
(or claw-backs) can be difficult to implement in
practice, especially if executives have paid tax
on any payouts. One solution is deferred payouts
that are subject to partial forfeiture if performance
subsequently deteriorates.
The second route by which incentive compensation
creates incentives for excessive risk taking is when
payouts are tied to performance metrics that either
implicitly or explicitly reward risky behavior. A clear
demonstration of this effect was evident in the run-up
to the recent global financial crisis, where incentive
systems operated by financial institutions that
rewarded individuals on the basis of the quantity of
lending decisions made rather than on the quality of
those decisions, as reflected in borrowers’ ability to
repay (Conyon et al. 2013). (See section 8.5 below for
a broader discussion of the links between executive
compensation and the financial crisis.)
8.5 THREATS TO CORPORATE CULTURE
In addition to the problems of investment myopia
and earnings management, Jensen (2003: 380)
highlights the broader organisational consequences
of using inappropriate performance metrics that “…
reward people for lying … and punish them for telling
the truth.” Jensen (2003) argues that such systems
and the gaming behaviour they engender threaten
corporate value in several ways. First, gaming strips
the accounting system of critical unbiased information
required to coordinate disparate elements of the
organisation. Second, gaming behaviour by senior
executive sets the tone for all other parts of the
organisation and even its relationship with outside
stakeholders.
8.6 EXECUTIVE COMPENSATION AND THE
FINANCIAL CRISIS
The recent global financial crisis raised concerns
about the role of compensation arrangements in the
financial services sector and in particular whether the
structure of executive compensation contracts created
incentives for excessive risk taking. For example,
former Financial Services Authority chairman Adair
Turner observed that “there is widespread concern
that inappropriate (bankers’) remuneration schemes
contributed to the market crisis’ (cited in Farmer et al.
24 | www.cfauk.org
2013). The chain of logic linking bankers’ compensation
and the financial crisis typically involves the following
steps: the financial meltdown involved banks; banks
rely heavily on bonuses; and pay levels in banks are
very high (Conyon et al. 2013).
Empirical tests examining the relationship between
bank executive compensation and the financial crisis
provide mixed evidence. Fahlenbrach and Stulz (2011)
investigate 95 U.S. banks from 2006 to 2008 and
find that CEOs with better incentives (more equity
incentives) faced strong motives to take appropriate
risks, since their firms performed worse during the
crisis. Similarly, Cheng et al. (2010) find evidence that
executives whose incentives were better aligned with
those of shareholders were associated with superior
performance before the crisis but suffered larger
losses during the crisis. Focusing on the UK, Gregg et al.
(2012) find no evidence that the cash pay-performance
sensitivity for financial firms was significantly higher
than in other sectors, leading them to conclude that
incentive structures are unlikely to have induced
bank executives to focus excessively on short-term
results. Meanwhile, Murphy (2009) shows that average
executive bonuses at banks participating in the
Troubled Asset Relief Program (TARP) decreased by
84 percent compared with a decline of 20 percent for
non-TARP banks. One interpretation of these
findings is that bank executives faced strong
incentives to avoid risk taking. Theory also suggests
that if bank executives had advance knowledge
about the crisis they would have engaged actions to
hedge their risk. However, neither Fahlenbrach and
Stulz (2011) nor Murphy (2009) find evidence supporting
such behaviour.
Other work provides some support for a link between
pay structures and excessive risk-taking in the banking
sector. For example, Erkens et al. (2012) study losses
at 206 banks in 31 countries and conclude that both
ex ante risk taking and ex post losses are greater
when CEOs receive higher cash bonus compensation.
Bebchuk and Spamann (2010) argue that the capital
structure at financial institutions led to risk-oriented
behaviour by CEOs before the crisis aimed at boosting
stock prices. In related work, Cai et al. (2010) argue that
compensation contracts are designed to maximise
shareholders’ wealth instead of debtholders’ wealth.
Since banks are characterised by higher debt levels
and greater financial leverage, traditional compensation
contracts create a bias toward excessive risk taking in
the banking sector. Results reported by Cai et al. (2010)
are consistent with Conyon et al.’s (2013) argument
that choice of inappropriate performance measures,
rather than pay levels or the link between pay and
performance per se, was a primary driver of poor
decision making among financial institutions.
9 THE PARADOX OF EXECUTIVE
COMPENSATION PLAN DESIGN
Evidence presented in the previous section suggests
that the weaknesses of commonly employed
metrics linking executive pay with firm performance
are numerous, economically significant, and well
documented. Given widespread public outrage over
executive pay arrangements in general and the
potential disconnect between pay and value creation
in particular, coupled with extensive theoretical
and empirical evidence regarding the limitations of
traditional accounting- and market-based measures
of performance, it is surprising that prevailing
compensation structures appear so resilient. This
section considers how such an outcome can persist
as a stable equilibrium when the weaknesses appear
so clear.
conditions. It is widely accepted that EPS targets
correlate poorly with long-term value creation and
encourage overinvestment (Brealey et al. 2008,
889); and yet this performance criterion remains in
widespread use. Research suggests that EPS-based
compensation plans can provide a simple, low cost
means of addressing agency conflicts between
managers and shareholders by incentivising managers
to take decisions that promote shareholder value. For
example, EPS performance conditions help mitigate
ownership dilution (Huang et al. 2010). Similarly,
because per share-based targets create incentives
for management to manipulate reported performance
by repurchasing stock, EPS-based compensation
can motivate executives to distribute surplus cash,
increase leverage, and correct underpricing in a timely
manner (Young and Yang 2011). Such “hidden” benefits
may help to explain why EPS-based targets remain a
popular choice in executive compensation contracts
despite their obvious limitations. Similarly, Wiseman
and Gomez-Mejia (1998) demonstrate how simple
external metrics such as share price can help promote
better risk alignment by encouraging executives to take
more risk.
Several (non-mutually exclusive) reasons may account
for the persistence of apparently flawed executive
compensation arrangements. Perhaps the simplest
explanation reflects the second-best nature of
compensation contracting and periodic performance
measurement. In the absence of first-best solution,
firms settle on second-best arrangements in which
the alignment benefits of prevailing compensation
arrangements outweigh the costs described above.
These costs represent part of the residual agency
costs of economic organisation that contracting
parties deem too costly to eradicate. Under this
view, corporate boards, regulators, and other
governance mechanisms seek to minimise agency
compensation-related costs up to the point where
the marginal cost of further reductions outweigh the
marginal gains to capital providers.
A third explanation for the persistence of seemingly
flawed compensation structures draws on the theory
of limits to arbitrage (Shleifer and Vishny 1997, Gromb
and Vayanos 2010). In an efficient market, failure to
link executive pay to long-term value creation and the
likely dysfunctional outcomes resulting from the use of
naïve or inappropriate performance measures should
result in predictable value losses and hence arbitrage
opportunities. The absence of any robust evidence that
firms with poorly designed executive compensation
arrangements trade at a material discount suggests
that investors may face limits of arbitrage. For
example, fund managers subject to short-term (e.g.,
quarterly) performance appraisal horizons may face
weak incentives to trade when compensation-related
valuation consequences only materialise in the
medium- to long-term (i.e., mispricing exists over an
extended period).
Efficient contracting offers a related explanation for
the prevailing compensation equilibrium. Although
current arrangements may appear inefficient and
prone to unintended consequences, it is possible that
apparent weaknesses mask important benefits. Take
for example the ubiquitous use of EPS performance
Managerial power theory provides another
explanation for the resilience of prevailing executive
compensation arrangements. Motivated by high
compensation levels and evidence of weak linkages
with performance, managerial power theory
presents executive compensation as a suboptimal
www.cfauk.org | 25
arrangement where senior executives extract
economic rents from shareholders (Bebchuk and Fried
2004, 2006). The theory has its roots in traditional
principal-agent models but includes the additional
insight that executives can influence both the level and
composition of their own pay packages. Managerial
power theory argues that compensation contracts
are not the outcome of arm’s-length contracting. A
primary implication of this view is that rather than
representing a solution to the corporate governance
problem, executive compensation is part of the agency
problem. In particular, Bebchuk and Fried (2004,
2006) argue that the both the level and composition
of pay are determined by captive board members
catering to rent-seeking entrenched executives.
Accordingly, executives are characterised as setting
pay in their own interests rather than in the interest of
shareholders, and as a consequence executive pay
is excessive. Nevertheless, the degree of managerial
power is limited by outrage constraints (e.g., financial
media backlashes and the risk of political intervention)
and therefore executives extract rents through
difficult-to-observe or assess forms of compensation.
Evidence supporting the managerial power perspective
is mixed. Consistent with the managerial power
hypothesis, Morse et al. (2011) predict that powerful U.S.
CEOs rig incentive pay by inducing boards to shift the
weight on performance measures toward those that
present the most favourable view of firm performance.
Results suggest find that rigging accounts for at least
10% of the pay-performance sensitivity and is positively
correlated with CEO human capital and firm volatility.
In contrast, De Angelis and Grinstein (2014) examine
cross-sectional variation in performance measures and
conclude that metric selection is more consistent with
predictions from optimal contracting theories insofar
as firms appear to rely on performance measures that
are informative of executives’ actions. In particular, their
findings provide no support for Bebchuk and Fried’s
(2003) managerial power hypothesis that entrenched
CEOs rig the contractual terms toward performance
measures that are easier to manipulate.
10 REVIEW AND DISCUSSION
10.1 FOCUSING ON VALUE CREATION
A stand-out feature of the collective empircial evidence
on performance measure selection reviewed in section
7 is the lack of clear links between compensation
26 | www.cfauk.org
outcomes and measures of fundamental value creation
that capture firms’ strategic priorties and the extent
to which these priorities are being implemented
effectively. Further, the most commonly used metrics
are associated with dysfunctional, value-reducing
activities as reviewed in section 8. Two features
of current practice are particularly striking: (i) the
dominance of equity-level performance measures and
corresponding infrequent use of entity-level metrics
such as free cash flow and NOPAT that capture returns
to all claimholders, and (ii) the derth of metrics such as
residual income and economic profit that benchmark
periodic performance against the cost of capital.
Although consistent with traditional principal-agent
models, the dominance of equity-based metrics such
as EPS and TSR contrasts with the main source of
financing for UK business. CFA UK (2011a) conclude
that less than one percent of UK business entities
meeting the legal definition of a company are publicly
listed and that as a result most companies rely on
non-equity sources of capital (in particular debt) to
achieve their long-term objectives. Insofar as most
UK companies, even those with significant equity
listings, rely on finance from non-equity sources, the
issue of measuring periodic performance and value
creation shifts from a narrow emphasis on shareholder
returns to a broader focus on value generation for all
claimholders. It is within this context that CFA UK (2011a)
criticised the Kay Review for adopting an excessively
narrow focus on the UK equity market and shareholder
returns at the expense of other asset classes.
The low incidents of performance measures that
benchmark returns against the cost of capital is
also a potential cause for concern. CFA UK (2011a)
surveyed members’ views on executive compensation
arrangements in response to the Kay Review (2012).
Results revealed serious disquiet with respect to
prevailing executive compensation arrangements.
From the 267 responses received from analysts and
investors:
»» 63 percent felt that boards and senior executives
paid too much attention to short term share price
movements;
»» 86 percent agreed or strongly agreed that boards
and senior executives of UK listed companies should
focus on economic profits ahead of accounting
profits;
»» 88 percent agreed or strongly agreed that to
generate economic value a publicly listed company
should at least cover its weighted cost of capital
(equity and non-equity);
These responses in turn led CFA UK to express doubts
over the proportion of senior UK executives that are
actually aware of their firm’s cost of capital, and
the fraction that know the extent to which their firm
generates returns in excess of its cost of capital.
Collectively, the evidence presented above supports
concerns expressed by a range of corporate
stakeholders that UK corporate managers and Boards
focus on accounting profit and (short-term) share price
performance rather than generating economic profits,
with the consequence that the link between executive
remuneration and models of economic value creation
tends to be weak (CFA UK 2011a and 2011b, Kay Review
2012, Towers Watson 2013). These views are consistent
with responses to a UK Government consultation
on long-term decision making and value creation,
which concluded that the tendency for companies
to rely on TSR and EPS as performance measures is
unhelpful (DBIS 2011). The High Pay Commission has
also expressed concern that prevailing compensation
arrangements reward executives for short-term
behaviour aimed at driving up share price; and that
this horizon problem is further compounded by
evidence that CEO tenure has shrunk to four years.
As a consequence, management face short-term
decision-making pressure aimed at boosting EPS
rather than improving productivity and investing in the
long-term future of the company (High Pay Commission
2014). Smithers (2014) argues that declining investment
rates and increasing profit margins is evidence
consistent with short-term pressure on executives
resulting in part from the way CEOs are incentivised
and rewarded. Finally, while Towers Watson (2013)
acknowledge the benefits associated with the general
increase in emphasis on pay for performance, they
also highlight the dangers of over-reliance on narrow,
simplistic measures of performance such as TSR
and EPS to the detriment of measures capturing
sustainable performance and fundamental value
creation. As Towers Watson (2013) stress, an important
distinction exists between paying for performance and
compensating management for strategic success.
CFA UK (2006) emphasised the importance of
focusing on long-term value creation. Amongst
their recommendations was that compensation for
corporate executives should be structured to achieve
long-term strategic and value-creation goals rather
than short-term targets based on accounting numbers
or share price movements. The Kay Review (2012)
also stressed the need for more focus on long-term
performance, albeit with an exclusive focus on equity
investors. The focus on long-term value creation
is a theme echoed by the National As-sociation of
Pension Funds (NAPF) in their most recent guidance on
executive compensation (NAPF 2013) and by The Aspen
Institute (2010). Specifically, NAPF (2013) highlight both
the unintended consequences of aligning executive
compensation with shareholder returns in the form
of overly aggressive payout policies and investment
strategies focused on short-term equity returns, and
the importance of linking rewards with performance
measures that directly reflect strategic objectives and
capture long term value creation. Similarly, The Aspen
Institute (2010) stress the need for management and
boards to recognise the existence of multiple types of
capital provider, balance these interests for long-term
success, and de-emphasise short-term financial
metrics such as quarterly EPS in favour of metrics that
reflect entities’ long-term strategic goals.
Concern over the way corporate performance is
measured for executive compensation purposes
expressed by The Kay Review, CFA UK, NAPF, DBIS,
and the High Pay Commission reflects something
of a disconnect with evidence on shareholder
voting behaviour in response to recent say on pay
developments. Following the introduction in 2002
of the advisory shareholder vote on the directors’
remuneration report in the UK, the average level of
dissent against remuneration reports in FTSE 350
companies oscillated between three and six percent
prior to the financial crisis. The onset of the financial
crisis predictably saw share-holder activism increase,
with 20 percent of shareholders of FTSE 100 companies
withholding support for the remuneration report in
2009 (DBIS 2011). Nevertheless, the level of dissent
remains surprisingly low given widespread concern
about executive pay. Further, although research
demonstrates that dissent is partly motivated by
perceptions of weak pay-performance sensitivity (Ferri
and Maber 2010; Carter and Zamora 2009), calls for
remedial action tend to focus more on strengthening
explicit links with conventional metrics such as EPS
and TSR rather than on the more nuanced issue of
www.cfauk.org | 27
which specific measure(s) of performance to use. In
particular, published research provides no evidence
that shareholder concern about a lack of alignment
between performance metrics and corporate strategy
is a significant driver of dissent over compensation
arrangements. Instead, debate often appears to fixate on
the quantum of pay. Of even greater concern is Towers
Watson’s (2013) evidence of a significant unintended
consequence of recent U.S. say on pay reforms in
the form of greater conformity in compensation plan
design (and in particular a shift toward more long-term
incentives linked directly to TSR).
Shareholders’ apparent indifference to prevailing
performance measures may be partially explained by
perceived alignment between shareholders’ interests
and commonly used metrics such as EPS and TSR. As
CFA UK (2011a) and Towers Watson (2013) acknowledge,
however, the distinction should be made between value
generation and return generation. While the former is
consistent with a value-based management approach
that stresses returns to all claimants in excess of the
cost capital, the latter typically involves returns to
shareholders resulting from share price movements
over an investor’s preferred investment horizon. In
addition to value creation, return generation also
recognises and exploits the fact that share prices may
deviate from fundamentals for a variety of economic
and behavioural reasons. As the academic literature
and policy debate on investment myopia clearly
demonstrates, measures of return generation such as
EPS growth and TSR do not necessarily align perfectly
with long-term value creation.
10.2 EMERGING TRENDS
Notwithstanding evidence of low shareholder
engagement with the issue of performance metric
selection via the say-on-pay initiative, UK companies
are facing increased pressure to demonstrate how the
measures linking executive compensation with firm
performance align with business strategy. PwC (2012)
note the increasing trend toward the use of bonus plan
performance metrics that are more aligned to business
performance indicators: the vast majority of FTSE 350
firms use a combination of financial, non-financial and
personal targets, with non-financial (financial) being
more common among FTSE-250 (FTSE-100) firms. A
similar trend is also evident with respect to long-term
incentive arrangements. For example, although TSR
and EPS continue to dominate in share incentive plans,
FTSE 100 firms are increasingly using these metrics in
conjunction with other measures which may be more
aligned to a company’s strategic objectives (PwC
2012, KPMG 2013). There is also evidence that FTSE
100 companies are starting to combine traditional
metrics such as TSR and EPS with alternative
performance metrics such as cash flow and return on
invested capital (Deloitte 2010). Accordingly, CEO pay
in large firms appears to be increasingly contingent
on a balanced set of performance metrics (beyond
traditional accounting- and market-based metrics) that
designed to link more closely with companies’ strategic
priorities and business model (Kaplan and Norton 1992).
Nevertheless, benchmarking periodic returns against
the entity’s cost of capital remains the exception rather
than the norm.
Expanding the set of performance metrics to deliver
better strategic alignment involves trading-off the
benefits of improved line of sight with value creation
against the costs of greater complexity. Research
suggests that executives tend to discount the
value of remuneration subject to complex long-term
performance criteria, particularly if they feel they have
little control over those criteria (Towers Watson 2011).
This in turn may drive increases in overall remuneration
because executives expect higher pay in reward for
higher risk (DBIS 2011). Complexity also risks obscuring
shareholders’ line of sight between the levels and
structure of remuneration and executives’ performance
in meeting their company‘s strategic objectives
(DBIS 2011, PwC 2010). It has also been suggested
that complex schemes increase the likelihood that at
least some elements will pay out, leading to higher
overall pay awards. These concerns have led some
stakeholders to suggest that the challenges associated
with establishing the right mix of performance
measures, together with lack of convincing evidence
demonstrating that more complex remuneration
structures help improve decision making and drive
company performance, points to the need for a radical
simplification of executive remuneration arrangements
(PwC 2011). 17
17For example, recent guidelines from the ABI recommends just three elements: fixed pay, bonus, and one LTIP. Some are going further and proposing a radical simplification of the
LTIP itself. One approach that has received a lot of attention is HSBC’s “performance on grant model”. Here the conventional LTIP is replaced by an award of shares made according
to pre-grant criteria, with a longer than usual vesting period (five years) during which shares are subject to claw-back, and executives are subject to an extended shareholding
requirement (KPMG 2013). The idea of career shares is also been proposed by Main et al. (2011) and discussed by DBIS (2011: 35).
28 | www.cfauk.org
11 SUMMARY AND CONCLUSIONS
Key insights emerging from our review of the academic
and professional literatures on executive compensation
and corporate value creation are as follows:
»» Economic theory provides guidance on
compensation plan design and the importance of
linking rewards to observable outcomes. However,
while theory dictates that investment decisions
should be made on the basis of discounted cash
flows and the net present value rule, periodic
performance measurement poses challenges
for which economic theory provides only limited
guidance. As a result, theory offers little direct
help with the practicalities of measuring economic
outcomes against which managerial performance
should be judged and rewarded.
»» An effective performance measure should capture
whether executives have generated adequate
returns on the resources at their disposal, while also
ensuring management make appropriate investment
decisions (i.e., invest in additional resources only
when such investments produce an adequate return
and divest existing assets that are not yielding an
adequate return). Firms create value when they
generate economic profits, defined as returns that
meet or exceed the entity’s cost of capital. Economic
profits differ from accounting profits and share
returns because the latter metrics do not include
a periodic charge for the cost of invested capital.
Failure to benchmark periodic performance against
the opportunity cost of funds can lead to misleading
signals regarding the degree of value creation during
the measurement period.
»» In the absence of a first-best measure of periodic
performance, corporate boards and compensation
consultants employ metrics that yield the most
efficient second-best solution to the problem of
measuring and incentivising executive performance.
»» Contrary to insights from the value-based
management literature, mainstream research and
practice focuses on simplistic measures of periodic
performance such as earnings per share (EPS)
and total shareholder return (TSR) that (i) focus
exclusively on returns to shareholders and (ii) ignore
the cost of capital.
»» Prevailing practice supports concerns expressed by
a range of corporate stakeholders that UK corporate
managers and boards place excessive emphasis
on accounting profit and (short-term) share price
performance, with a consequence that the link
between executive pay and models of economic
value creation tends to be weak. There exists a
danger that corporate boards may be failing to
recognise the crucial distinction between paying for
performance and compensating management for
strategic success.
»» The unintended consequences of over-reliance on
narrow, simplistic performance metrics that align
poorly with value creation are well documented
in the academic literature. The negative effects
of using inappropriate performance metrics to
evaluate, incentivise and reward executives include
investment myopia, earnings manipulation, excessive
risk taking, and threats to organisational culture.
»» The majority of investor and media debate
surrounding the link between executive pay and
corporate performance continues to focus primarily
on strengthening explicit links with conventional
performance metrics such as EPS and TSR rather
than on the more important issue of selecting the
most appropriate measure(s) of performance to
use. An increasing trend toward using performance
metrics more closely aligned to key performance
indicators and long-term value creation is
nevertheless apparent, although bench-marking
periodic returns against the entity’s cost of capital
remains the exception rather than the norm.
»» Empirical evidence highlights two striking features of
current practice. First, the dominance of equity-level
performance measures and corresponding
infrequent use of entity-level metrics such as free
cash flow (FCF) and net operating profit after tax
(NOPAT) that capture returns to all claimholders.
Second, the derth of metrics such as residual income
(RI) that benchmark periodic performance against
the cost of capital.
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PART 2:
EMPIRICAL ANALYSIS
This component of the report presents empirical
evidence on executive compensation plan design and
links with value creation for a representative sample of
FTSE-100 companies, with complete data for the period
2003 to 2013. The research is structured according to
the following eight sections. The next section outlines
the aims and scope of the analysis. Section 13 provides
details of our research design, including definition and
measurement of key performance-related variables
- such as cost of capital, free cash flow, residual
income, TSR and EPS growth - as well as details of
the methods used to compute the equity-based
component of executive compensation. Section 14
reviews our sampling procedure and reports summary
statistics relating to compensation plan design and our
annual performance metrics. Sections 15 to 18 present
our empirical findings and section 19 concludes.
12 AIMS AND SCOPE
The empirical analysis seeks evidence on the following
questions using data for a sample of large companies
listed on the London Stock Exchange:
1 What is the degree of alignment between alternative
measures of periodic performance?
The review presented in Part 1 highlights a range
of alternative approaches to measuring periodic
performance and value creation, and the potential
drawbacks associated with various approaches.
Given the importance for compensation plan design
of selecting performance metric(s) that encourage
and reward appropriate investment and operating
behaviour, evidence is required on the degree to
which alternative metrics provide similar or conflicting
signals with respect to periodic performance and
value creation. We compare the degree of alignment
(correlation) between the performance signals provided
by the following group of metrics: total shareholder
return (TSR), free cash flow to the firm (FCF), residual
income to the firm (RI), cash flow return on investment
(CFROI), return on assets (ROA), return on equity (ROE),
and earnings per share (EPS) growth.
2 To what extent is executive compensation aligned
with various measures of periodic performance,
with particular emphasis on the extent of correlation
between compensation and value creation?
30 | www.cfauk.org
Effective executive compensation arrangements
are those that incentivise and reward behaviour that
generates value for the providers of capital to the
business. An important empirical question concerning
executive compensation arrangements in the UK
concerns the degree to which remuneration outcomes
are linked to value creation. We seek evidence on the
aspects of company performance that correlate with
executive remuneration outcomes, and the extent to
which compensation realisations are linked to periodic
value creation metrics versus alternative performance
measures whose association with value generation is
less obvious.
3 How do the performance metrics employed in
executive compensation plans align with the key
performance indicators that drive value at the individual
company level?
Effective strategy implementation involves measuring
and managing the core metric(s) that influence how
value within a business is created. Companies are
increasingly disclosing information on the critical
success factors or key performance indicators (KPIs)
that are predicted to drive organisational success.
An important empirical question concerns the degree
of alignment between remuneration arrangements
designed to incentivise and reward executive
performance and these core drivers of business
success. Accordingly, we seek evidence on the extent
to which firm-specific KPIs are reflected in executive
compensation arrangements.
Empirical tests focus on CEO compensation
arrangements for several reasons. First, as the most
senior executive in the company, compensation
arrangements for the CEO attract the most attention
from external parties and arguably have the largest
potential impact on organisational performance
and strategic direction. Second, CEO pay structures
are a good proxy for executive-level compensation
arrangements, more generally because executive
compensation plan design at the firm level typically
shares the same core features for all board-level
executives (albeit with some variation in key
parameters). Third, focusing on the compensation
practices of a single senior executive per company
simplifies our empirical analyses without risking any
significant loss of information.
13 RESEARCH DESIGN AND
VARIABLE DEFINITIONS
This section provides an overview of our research
methods, explains the definition of performance and
compensation variables used in our empirical tests,
and summarises the data sources used to obtain the
inputs for these variables.
13.1 RESEARCH DESIGN
Empirical analyses are based on a sample of FTSE-100
firms. We require each firm in the final sample to
have an 11-year time-series of performance and CEO
compensation data beginning in 2003. 18 The sample
period starts in 2003 to coincide with improved
disclosure on executive compensation arrangements
following implementation of the Directors’
Remuneration Reporting Regulations with effect from
December 2002. We use this data to address our core
research questions as follows:
1 What is the degree of alignment between alternative
measures of periodic performance?
To address this question, we compute correlations
between all pairs of performance metrics. We
implement the correlation analysis using two
complimentary approaches. The first approach (pooled
analysis) combines data over time and across firms to
provide a global measure of the degree to which any
two performance metrics track each other. The second
approach (firm-level analysis) computes separate
firm-specific correlations using a time-series of
eleven observations per firm, which are then averaged
across firms.
2 To what extent is executive compensation aligned
with alternative measures of periodic performance,
with particular emphasis on the extent of alignment
between compensation and value creation?
We address this issue in a similar way to the previous
question by computing pooled and firm-level
correlations between CEO pay and the jth performance
metric, where j = TSR, FCF, RI, CFROI, ROA, ROE, and EPS
growth. We also conduct a series of supplementary
analyses where we partition the sample on the basis
of contracted performance metrics and then compare
measures of value creation, compensation, and a range
of additional dimensions including EPS growth relative
to the return on invested capital, earnings quality,
and share repurchase activity across the partitions
to provide further insights into the consequences of
prevailing compensation arrangements.
3 How do the performance metrics employed in
executive compensation plans align with the KPIs that
drive value at the individual company level?
We seek evidence on this question by comparing the
degree of alignment between the performance metrics
employed in CEO compensation contracts and the KPIs
disclosed by firms in their annual report and accounts.
Due to lack of disclosure in some firm-years, empirical
tests are based on the subset of observations where
KPI details are provided.
Data for our empirical tests are obtained from a
variety of sources. Financial statement and market
data are taken from Thomson Reuters Datastream,
which aggregates information from a range of
specialist sources including national governments,
the Organisation of Economic Cooperation and
Development, the Economic Intelligence Unit, the
International Monetary Fund, Worldscope, and Morgan
Stanley Capital. Analysts’ consensus EPS forecasts
are obtained from The Institutional Brokers’ Estimate
System (IBES), along with corresponding actual
EPS numbers that represent GAAP EPS adjusted for
various transitory and non-cash items. Finally, we use
companies’ published annual report and accounts
(accessed via Perfect Information) as the source
of information on CEO compensation payments,
contractual arrangements, and KPIs (where disclosed).
An inevitable consequence of constructing empirical
proxies based on financial statement and market
data is the presence of extreme observations.
Measures such as EPS growth that are influenced by
large charges such as impairments, write-offs, and
restructuring expenses, and cost of capital proxies that
rely on volatile market data are particularly susceptible
to extreme outcomes. Such observations pose a
significant challenge to the empirical analysis given
our relatively small sample size and our firm-level
analyses that are based on short time-series (11 years).
These data problems mirror those faced by any market
participant computing performance metrics using
18Our empirical tests do not adjust for CEO turnover during the sample window. Failure to adjust for turnover is expected to introduce noise into our analyses leading to a
downward-biased estimate of the association between CEO pay and firm performance.
www.cfauk.org | 31
published accounting data and market prices that
are subject to short-term volatility. Failure to address
the problem of extreme observations will confound
our analysis and skew resulting conclusions. Further
details of how we address the problem of extreme
observations are provided below.
13.2 VARIABLE DEFINITIONS
13.2.1 Performance metrics
Total shareholder return (TSR)
TSR reflects the total periodic return from holding a
share arising from both distributions (e.g., dividend
payments) and changes in the price of the share.
Gregory-Smith and Main (2012) compute annual TSR for
firm i during fiscal year t using Datastream’s return index
datatype:
TSRit = ⎡⎣( RetI id1 − RetI id 2 ) −1⎤⎦ ×100
where RetI is the daily Datastream return index (defined
as the theoretical growth in value of a shareholding
over a one-day period, assuming that dividends are
re-invested to purchase additional units of the stock),
and d1 (d2) is the last (first) day of fiscal year t. In
subsequent tests we focus on absolute TSR rather than
TSR benchmarked against a share index or a peer group.
The latter approach is the norm in CEO compensation
contracts in the UK and therefore our results should be
interpreted with this caveat in mind.
Free cash flow to the firm (FCF)
Although the conceptual definition of FCF to the firm
is unambiguous, a range of different approaches to
implementing this metric have been proposed (Adhikari
and Duru 2006). In addition to the standard textbook
approaches, investment practitioners tracking a small
number of stocks often apply a series of firm-specific
adjustments designed to provide a more refined
measure. The nature of our analysis is such that
idiosyncratic accrual adjustments using information
from the notes to the financial statements are not
feasible. By way of compromise, we use two short-cut
approaches to measuring FCF that are widely applied
in standard financial statement analysis and corporate
finance textbooks, as well as in the academic research
literature. The first approach follows Penman (2012) and
utilises data from the cash flow statement to produce a
cash flow-based estimate for FCF (FCFCash):
⎛
⎞ ⎛
⎞
Equityit
Debtit
WACCit = ⎜
× Rite ⎟ + ⎜
× Ritd × (1− Tax rateit ) ⎟
⎝ Equityit + Debtit
⎠ ⎝ Equityit + Debtit
⎠
FCFitCash = NOCFit − NICFit
where Equity is the book value of shareholders’ equity
(WC03995), Debt is the book value of debt (WC03251),
Re is the cost of equity capital, Rd is the cost of debt
capital, and Tax rate is as defined above. We use the
CAPM (Sharpe 1964, Lintner 1965) to estimate Re and
then assess the sensitivity of the resulting values
to alternative estimation procedures including the
Fama-French three factor model (Fama and French
1993) and the implied cost of capital estimated via the
abnormal earnings growth model. 20 We set Rd equal to
the basis spread corresponding to the following bands
for the standard deviation of equity returns (∂t) (http://
people.stern.nyu.edu/adamodar/), where subscripts i
and t refer to firm and calendar year, respectively, and ∂
is computed using daily returns and then annualised for
each firm-calendar year:
where NOCF is net operating cash flow (Worldscope
code WC04860) and NICF is net cash flow from
investments (WC04870). This approach provides
a capital maintenance perspective on free cash
flow insofar as it captures the amount of cash that
management may consume within a period without
reducing the value of the business (by adjusting net
operating cash flow for investing activities including
capital expenditures). 19 The starting point for our
second FCF measure is net income, which we then
adjusted as described in Damodaran (1996) and Brealey,
Myers and Marcus (1995) to produce an earnings-based
estimate (FCFIncome):
FCFitIncome = FFOit − CAPEXit − Dit
where FFO is funds from operations which is measured
as net income plus non-cash charges (WC04201), CAPEX
is total capital expenditure during the period (WC04601),
and D is cash dividends paid (WC04551). This approach
provides an all-inclusive perspective on free cash
flow by adjusting for both investing and financing
activities. Since both perspectives are extensively used
by management (Adhikari and Duru 2006), we report
results using both measures.
Residual income to the firm (RI)
Residual income to all capital providers in the company
is periodic profit less a charge for invested capital and is
computed using equation (3) from Part 1. The calculation
involves three key variables: net operating profit after
tax (NOPAT), invested capital (IC), and the weighted
average cost of capital (WACC). We defined NOPAT
as EBIT × (1 – Tax rate), where EBIT is earnings before
interest and tax (WC18191), and Tax rate is (WC08346).
Invested capital is equal to Net Fixed Assets (WC02501)
plus Current Assets (WC02201) minus Current Liabilities
(WC03101) minus Cash (WC02003). Finally, our firm- and
time-varying measure of WACC is computed as:
19An important feature of the capital maintenance perspective represented by equation (5) is that NICF includes the effect of fixed asset disposals, net changes in investments, and
net changes in other assets in addition to capital expenditures. Inclusion of these additional components can lead to extreme (negative) values for NICF, which in turn can lead to
negative realizations for FCFCash. Given uncertainty over specific elements included in net changes in other assets, in sensitivity tests we employed two alternative versions of
equation (5). The first version sets FCFCash equal to NOCF minus the cumulative value of capital expenditure plus net cash flow from change in investments plus cash from fixed
asset disposals. The second version sets FCFCash equal to net income minus interest income plus depreciation and amortization minus net gains on asset sales minus change in
working capital accruals minus capital expenditures plus net cash flow from change in investments plus cash from fixed asset disposals. Results using both alternative measures
are entirely consistent with those reported in Tables 7-10 using FCFCash. (Results are available from the authors on request.)
32 | www.cfauk.org
Standard deviation
categories
Basis spread
(%)
≥ 0.00 to
< 0.25
0.50
≥ 0.25 to
< 0.50
1.00
≥ 0.50 to
< 0.65
1.50
≥ 0.65 to
< 0.80
2.00
≥ 0.80 to
< 0.90
2.50
≥ 0.90 to
< 1.00
3.00
≥ 1.00 to
< 10.00
4.00
Supplementary tests designed to assess the
robustness of WACC to cost of debt measure utilised
three alternative methods. The first method sets Rd
equal to the weighted average yield on the firm’s
outstanding bonds:
J
Ritd = ∑ ( RYij × PBij )
where SP is the bond yield spread defined as the
difference between the yield on the jth bond issue and
the yield on an equivalent UK government benchmark
bond (i.e., similar maturity), measured in basis
points. The third approach uses the option adjusted
spread (OAS) to account for the imbedded option
risk component in bond spreads. The OAS measures
the yield spread that is not directly attributable to a
security's characteristics. 21
Cash flow return on investment (CFROI)
Boston Consulting Group/Holt Value Associates’ CFROI
measure for firm i in fiscal year t is defined as:
CFROI it =
Gross cash flowit
Gross invested capitalit
Gross cash flow is inflation-adjusted cash flows
available to all capital owners in the company (i.e. cash
flow before tax and investment), defined as:
Gross cash flowit = OCFit + TCFit + IPCFit − IICFit
where OCF is operating cash flow (WC04201), TCF is
cash taxes paid (WC04150), IPCF is cash interest paid
(WC04148), and IICF is cash interest income (WC04149).
Gross invested capital is the gross accumulated
investment provided by capital owners and is
measured as:
Gross invested capitalit = NA it + CAit − CLit − Cashit
where NA is net fixed assets (WC02501), CA is current
assets (WC02201), CL is current liabilities (WC03101), and
Cash is cash and cash equivalents (WC02003).
j=1
where RY is the average redemption yield on the jth bond
issue and PB is market value of the jth bond issue as a
fraction of the aggregate market value of all J bonds in
issue at the corresponding date. The second method
uses credit spread (CS) calculated following Kabir et al.
(2013) to proxy for Rd:
J
CSit = ∑ ( SPij × PBij )
j=1
Other earnings-based performance measures
Earnings per share (EPS) growth is calculated as
change in EPS between the current and previous period
divided by EPS in the previous period:
EPS growthit =
EPSit − EPSit-1
EPSit-1
where EPS is earnings after taxes divided by the
weighted average number of shares outstanding
20The CAPM and Fama-French three factor model has been subject to criticism in the academic literature (Mishra and O'Brien 2013, Kothari et al. 1995, Jegadeesh and Titman 1993,
Carhart 1997, Griffin and Lemmon 2002, Daske et al. 2006)
21Due to constraints on data availability, OAS is only computable for 145 observations relating to 17 firms. Supplementary tests using all three alternative cost of debt proxies yield
results and conclusions that are entirely consistent with those reported below. Results of these supplementary tests are available from the authors on request. We are grateful to
Mikkel Velin and Rogge Global Partners for help and advice with cost of debt calculations and for providing data for computing OAS..
www.cfauk.org | 33
during the fiscal year. We define EPS as core earnings
per share based on actual earnings from IBES, which is
equivalent to GAAP earnings before transitory gains and
losses. 22 Core EPS is designed to capture underlying
or sustainable earnings performance. We report
results using core EPS to better capture underlying,
sustainable earnings performance.
We also use return on assets (ROA) and return on equity
(ROE). ROA is equal to:
ROAit =
Incomeit
Total assetsit
where total assets are the sum of total current assets,
long term receivables, investment in unconsolidated
subsidiaries, other investments, net property plant
and equipment and other assets (WC02999). ROE is
defined as net income (WC01651) divided by the book
value of shareholders’ equity (WC03995):
ROEit =
Net Incomeit
Equity it
13.2.2 Contractual performance measures
Information on the performance metrics used in
CEO compensation contracts are collected from the
remuneration report section of firms’ published annual
report and accounts. We focus exclusively on CEO
compensation arrangements and record information
separately for each compensation component (annual
bonus, deferred bonus, share options, performance
share plans, etc.). Details of all contracted performance
measures relating to fiscal year t are recorded including
financial, quantitative non-financial, and qualitative
non-financial metrics. Where multiple metrics are
employed, we collect information on the fraction of total
rewards linked with each measure when disclosed,
as well as all disclosed performance standards. Our
focus for fiscal year t is restricted to measures linked
with compensation paid, granted or outstanding for
that year; we do not record details of new performance
measures proposed for introduction in t + n.
13.2.3 CEO remuneration
The annual amount of compensation received by
CEOs is defined as the sum of base salary (Salary),
cash bonus (Bonus), equity incentives (Equity),
and pensions plus other benefits (Other). The
compensation literature is characterised by a lack of
on consensus on how CEO equity incentives should
be measured. For completeness, therefore, we use
three alternative methods to compute the Equity
component, yielding three corresponding measures
of total CEO compensation. Our first Equity measure
employs the realised value of equity incentives
(options and restricted shares) using figures reported
in the compensation table presented as part of the
remuneration report. This measure provides an ex
post perspective on CEO pay, insofar as it captures the
aggregate cash amount received by the CEO during
fiscal year t. As this figure is disclosed directly in the
remuneration report, it is typically the number on which
media discussion and shareholder debate anchors,
and accordingly it represents the primary focus of our
analysis.
Our second measure of Equity employs the grant date
fair value of equity incentives awarded during the
fiscal year. This measure captures the value of equity
incentives granted during fiscal year t as if all new
awards were exercisable with immediate effect and as
such provides an ex ante estimate of the value of CEO
services purchased by shareholders over the vesting
period. This is the value of equity incentives that
accountants use as a basis for computing the periodic
compensation expense charged against reporting
earnings, and the one which is most commonly
employed in academic research on CEO compensation.
Since firms are not required to disclose the grant date
fair value of equity incentives awarded during the
fiscal year, we estimate this figure using the method
proposed by Core and Guay (2002b). Specifically, option
fair values (C) are estimated using the Black-Scholes
(1973) method:
C = S × N(d1 ) − K × e−rt × N(d2 )
S
ln( )
K +σ × T
d1 =
2
σ× T
d2 = d1 − σ × T
22IBES actual EPS is defined to ensure consistency with analysts’ consensus earnings forecast for a given firm. Analysts typically forecast earnings before non-recurring or
exceptional items. IBES reviews analysts’ treatment of individual earnings line items (e.g., restructuring charges) in their earnings forecast and adopts the majority treatment to
define the numerator in their actual EPS metric. For example, if the majority of analysts for firm i (j) exclude (include) goodwill impairment charges in their earnings forecasts then
actual EPS for firm i (j) will also exclude (include) this item.
34 | www.cfauk.org
where S is share price on the day the option is granted,
K is the agreed exercise price, ∂ is the annual standard
deviation of share returns, T is the time to maturity, r
is the risk-free interest rate, and N(d) is the cumulative
normal distribution (i.e. the probability that a normally
distributed variable is less than d). Information on
exercise price and maturity is taken from firms’ annual
reports. Share price is obtained from Datastream
(price index type P). We estimate ∂ using the
annualised standard deviation of monthly share returns
(Datastream price index type PI) computed over the 60
preceding months. The risk free rate is approximated
by the yield on UK Treasury Bills with a maturity of
three months (Datastream UKTBTND). Similarly, the fair
value of performance shares (i.e., restricted stock) is
calculated as the maximum shares awardable under
the plan multiplied by share price at the fiscal year-end.
Although using the maximum number of awardable
shares can overstate grant date values, Fernandes et
al. (2013) demonstrate that results are not sensitive to
this choice.
Our third measure of Equity is defined as the grant
date fair value of equity incentives awarded during
the fiscal year as described above plus the change in
the value of all direct CEO equity holdings during the
corresponding period. Insofar as direct equity holdings
represent a non-trivial component of CEO wealth,
as well as a powerful means of aligning CEO and
shareholder interests, this approach provides a more
comprehensive perspective on the level and change in
CEO wealth during fiscal year t. This measure has been
widely adopted in the academic research literature
over the last decade. We compute the end-of-year
value of CEO equity holdings as the product of the
number of shares held by the CEO at annual report date
t multiplied by share price on the corresponding date.
Annual changes in the value of CEO equity holdings are
computed as the difference between holdings at fiscal
year-end t + 1 and fiscal year-end t.
13.2.4 Rewards linked with contracted
performance measures
Two dimensions are relevant when examining the use
of performance measures in executive compensation
contract design: (a) the incidence of a particular
metric and (b) the fraction of variable compensation
contingent on that metric. Extant UK research and
survey evidence examining performance measures
employed in executive compensation contracts is
restricted to a binary analysis of the incidence of
performance measure usage. While informative, this
approach yields limited insights because it provides no
evidence on the relative importance of each metric in
determining total compensation outcomes.
To address this limitation we follow De Angelis and
Grinstein (2014) and estimate an ex ante measure of
performance-based compensation incentives defined
as the proportion of total incentive compensation
associated with the jth performance measure as
follows:
Maximum value of non-equity awardst
× w jt
Total compensation t
K ⎛
⎞
Fair value of maximum equity grant kt
+∑⎜
× w jkt ⎟
Total compensation t
⎠
k=1 ⎝
Weight jt =
where Weight is the fraction of total compensation
linked to performance metric j in year t, Maximum value
of non-equity awards is the maximum reward payable
in annual bonus (e.g., 2 × base salary) in year t, Fair
value of maximum equity grant is the grant date fair
value of the maximum equity award payable for the kth
equity-based component (e.g., share matching plans,
share option plans, and performance share plans) in
year t, Total compensation is the maximum value of
annual compensation payable in year t, and w is the
contractual weight associated with the jth performance
metric in year t. Supplementary data on compensation
weights required to operationalise equation (17) are
collected from the remuneration report section of firms’
annual report and accounts. 23 Note that equation (17)
employs both the maximum potential bonus payable
and the grant date fair value of equity incentives
based on the maximum number of shares awardable.
Accordingly, this set of analyses provides evidence
on the fraction of maximum potential compensation
payments linked to a given performance metric rather
than the fraction of realised compensation linked to
that metric.
13.2.5 KEY PERFORMANCE INDICATORS
Disclosure of KPI information is voluntary and as a
consequence some firms provide limited information,
23Where companies do not disclose the maximum ward for a given compensation element, we substitute the sample median. We assume performance metrics are equally
weighted for companies that use multiple performance metrics but do not disclose relative weights.
www.cfauk.org | 35
particularly in the early part of the sample period.
(Systematic disclosure of KPI information was patchy
before 2006.) We identify KPI information by searching
firms’ annual report and accounts using the following
keyword list: “KPI”, “key performance indicator”, and
“critical success factor”.
14 SAMPLE, DATA, AND SUMMARY
STATISTICS
14.1 SAMPLE SELECTION
The sampling frame for our analysis is FTSE-100 index
constituents as at September 2013. To measure
associations between alternative performance
metrics and to assess the degree to which executive
compensation payments correlate with these
alternative metrics, we require firms to have a complete
11-year time-series of data required to compute all
our main performance metrics and compensation
variables for the period 2003 to 2013. Sixty-seven firms
from the initial FTSE-100 constituent list satisfied this
condition, from which we selected 30 firms to form our
final sample. The sampling approach was stratified by
industry to ensure broad coverage of FTSE-100 industry
groups. We sought to select firms in proportion to the
overall FTSE-100 sector representation but with the
additional condition that the sample should include a
minimum of two firms from each sector where possible.
Where more than two firms with available data in a
given sector were available, we selected the largest
firms based on market capitalisation as at September
2013. The decision to focus on a subset of available
firms reflected the data demands of our tests and in
particular the need to collect a significant amount of
information manually from firms’ published annual
reports and accounts. The final sample therefore
comprises 330 annual observations relating to 30
companies, although some of our supplementary tests
use fewer observations due to missing data for certain
variables.
A list of sample firms grouped by sector and ranked in
descending order by market capitalisation within each
sector is presented in Table 1. All ten industrial sectors
in the original FTSE-100 constituent list are represented
in the final sample. The three industry groups with the
highest representation in our sample are industrials with
nine firms (30 percent), consumer services with five firms
(17 percent), and financials with four firms (13 percent).
Panel A: Realised values
Variable (£000)
TABLE 1
N
Mean
St. dev.
Min
Max
330
727
211
45
725
1,233
Annual bonus
330
644
491
0
550
3,300
Pension and other benefits
330
234
337
1
145
3,196
Realised value of share options
330
237
811
0
0
6,546
0
0
23,959
60
1,702
25,209
Technology
Rio Tinto
Sage group
Anglo American
Health Care
Consumer Goods
Glaxosmithkline
Realised value of restricted shares
330
358
1761
Associated British Foods
Smith & Nephew
Total compensation
330
2,199
2,159
Persimmon
Telecommunications
Panel B: Granted values for equity
Consumer Services
BT Group
Variable (£000)
Pearson
Oil & Gas
Total value of share option plan
Sainsbury (J)
BG Group
Next
Tullow Oil
Marks & Spencer Group
Utilities
Total compensation
Whitbread
Centrica
Financials
United Utilities Group
Standard Chartered
Median
Salary
Basic Materials
N
Mean
St. dev.
Min
Median
Max
330
162
526
0
0
7,833
Total value of performance share plan
330
1,831
2,227
0
1,346
23,192
Total value of share matching plan
330
130
478
0
0
4,576
330
3,726
2,657
60
3,073
24,317
Notes:
All compensation data are collected using remuneration report disclosures. Values for share options, restricted shares and total compensation relate to the realized value of equity
incentives. This measure represents an ex post perspective on CEO pay insofar as it captures the aggregate cash amount received by the CEO during fiscal year t. Results in Panel B
are based on the grant date fair value of equity incentives awarded during the fiscal year.
Aviva
Aberdeen Asset Management
Hammerson
Industrials
Rolls-Royce Holdings
BAE Systems
CRH
Wolseley
Bunzl
Aggreko
Weir Group
Rexam
Babcock International
Notes:
The sampling frame is FTSE 100 index
constituents as at September 2013.
We require firms to have a complete
11-year time-series of data required
to compute our main performance
metrics and compensation variables
for the period 2003 to 2013. Sixty-seven
firms from the initial FTSE 100
constituent list satisfied this condition,
from which we selected 30 firms using
a stratified sampling approach by
industry whereby firms were sampled
in proportion to the overall FTSE 100
sector representation but with the
additional condition that the sample
should include a minimum of two firms
from each sector wherever possible.
Where more than two firms with
available data in a given sector were
available, we selected the largest firms
based on market capitalisation as at
September 2013.
14.2 DESCRIPTIVE STATISTICS FOR COMPENSATION
PLAN DESIGN
Summary statistics for the components of CEO
compensation are reported in Table 2 using realised
values for equity incentives (Panel A) and the grant
date fair value of equity incentives (Panel B). The
median (mean) CEO received £1.7 (£2.2) million per year
in total compensation during the sample period. Total
realised compensation varies dramatically, ranging
from £0.6 million (Wolseley, 2009) to £25.2 million
(Tullow Oil, 2008). 24 Average base salary is £0.7 million
and accounts for approximately 33 percent of realised
annual total compensation. Variation in annual salary is
relatively narrow, ranging from a low of £0.5 million to
a high of £1.2 million. The most significant component
of realised CEO compensation is restricted shares and
other forms of performance share plan, representing
24The fair value of total granted compensation ranges from £0.6 million (Wolseley, 2009) to £24.3 million (Rolls Royce, 2008)..
36 | www.cfauk.org
TABLE 2
approximately 16 percent of mean total compensation.
Consistent with the trend away from share options
toward restricted stock, share appreciation rights
and other types of LITP, share options account for a
smaller (zero) fraction of mean (median) total annual
compensation. Long term pay comprising options,
LTIPs and share matching plans represents 27 percent
of mean total annual compensation and 48 percent of
variable pay. Short-term bonuses account for 17 percent
of average annual pay, with annual payouts ranging
from zero to £3.3 million. Using the grant date value of
equity incentives awarded in the period, results in Panel
B using show that restricted shares and other forms
of performance share plan represent approximately
52 percent of mean total compensation. Share option
grants account for a small (zero) fraction of mean
(median) total annual compensation. Overall, equity
grants represent 57 percent of mean total annual
compensation and 77 percent of variable pay in Panel
B. Collectively, the evidence in Table 2 is consistent
with the continuing drive toward more emphasis on
variable pay (linked to performance) and as such these
results serve to highlight the central importance of
performance metric choice in the context of executive
compensation contract design.
Panels A and B in Figure 1 report CEO compensation
by year and sector, respectively, based on the grant
date fair value of equity incentives awarded during
the period. An upward trend in total compensation is
evident in Panel A over the sample period, although
some evidence of plateauing is apparent from 2010
onwards. Total compensation increases from an
average of £2.4 million in 2003 to £4 million in 2012.
It is noteworthy that no material reduction in total
compensation is apparent during the financial crisis
2008 to 2011 despite weak corporate performance
over this period (see Panel A in Figure 2). The relative
importance of individual compensation components
suggests a subtle redistribution from fixed salary
to equity-based incentives over the sample period,
consistent with continuing pressure for more
performance-related pay. The trend toward more
share-based pay masks a substantial reduction
in share option grants, which is more than offset
by an increase in restricted share plans and share
matching plans.
Panel B in Figure 2 reveals substantial variation in total
CEO compensation by sector. Health care is associated
with the highest average total CEO compensation at
£7.3 million per year, followed by basic materials with
£6.7 million, and oil and gas with £5.7 million. Sectors
with the lowest average level of CEO compensation
are consumer goods and technology with £3.1 million.
The relative importance of individual compensation
components also varies across industries, with a
higher (lower) total realised compensation associated
with a higher fraction of long-term variable pay (salary).
For example, whereas fixed salary accounts for only 11
percent of mean total compensation in the health care
sector, the comparable fraction in the consumer goods
www.cfauk.org | 37
Year
RI (NOPAT)
CFROI
FCF (Cash)
FCF (Income)
0.30
0.20
Panel A: Performance metrics by time
7000
7000
90%
90%
RI and FCF £000
5000
5000
70%
70%
60%
60%
4000
4000
50%
50%
£000
£000
40%
40%
30%
30%
3000
3000
0.50
350000
0.45
0.20 2003 2004 2005 2006 2007 2008 2009 2010 2011
0.35
0.30
200000
0.25
150000
0.20
0.15
100000
0.05
0
0.00
0.10
TSR
0.00
CFROI
TSR
Share
Share based
based
Pension and
and other
Pension
other benefits
benefits
Share
Share based
based
Pension
Pension and
and other
other benefits
benefits
Annual
Annual Bonus
Bonus
Salary
Salary
Annual
Annual Bonus
Bonus
Salary
Salary
0.10
2000000
0.00
1600000
-0.10
1200000
-0.20
800000
-0.30
2000000
400000
2003 2004 2005 2006 2007 2008 2009 2010 2011
0.080
0.060
0.040
0.020
0.120
0.000
0.100 2003 2004 2005 2006 2007 2008 2009 2010 2011
Cost of equity
0.060
ie
ilit
om
m
Ut
ui
ca
ch
no
lo
tio
ns
gy
s
Te
WACC
FCF (Income)
RI (NOPAT)
Te
Co
n
Cost of debt
FCF (Cash)
CFROI (%)
lec
Oi
In
la
nd
al
du
s
tri
Ca
al
th
He
Ga
s
re
ls
cia
Fin
su
m
su
er
m
er
Se
an
rv
Go
ice
s
s
od
ls
ia
er
s
Cost of equity
ie
s
ilit
Ut
ui
ca
om
m
lec
Oi
Te
la
ch
nd
no
lo
tio
ns
gy
s
Ga
ls
ria
In
du
st
th
al
su
m
He
Fin
er
Ca
re
ls
an
rv
ic
Se
cia
es
s
od
Go
m
er
su
Co
n
Te
TSR
ROA
s
ie
EPS growth
m
ui
Ut
ca
ilit
ns
tio
lo
no
Te
la
ch
nd
ria
du
st
gy
Ga
s
ls
ROE
2012 2013
Oi
He
EPS growth
In
re
al
th
Ca
cia
an
Fin
ROE
om
ns
um
er
um
ls
s
er
Se
rv
Go
ice
s
od
ls
s
ie
ilit
Ut
ns
Te
lec
om
Te
m
ui
ch
ca
no
tio
lo
g
y
s
nd
la
Oi
In
du
st
ria
Ga
ls
e
Ca
r
al
th
He
an
Fin
er
um
ns
Co
cia
es
rv
ic
Se
er
um
ns
Co
ls
Te
Co
ds
Go
o
ia
l
er
at
M
sic
lec
ns
WACC
Cost0.20
of equity
Cost of debt
Notes:
0.00
Variable definitions are as follows: FCF(Cash) is defined from a capital maintenance perspective and is equal to net operating cash flow minus net cash
flow from investments; FCF(Income) is defined from an all-inclusive perspective and is equal to net income plus non-cash charges, minus total capital
expenditure and cash dividends; RI (NOPAT) is net operating profit after tax less a capital charge equal to the product of book value of net assets and a
firm- and time-varying estimate of the weighted average cost of capital (see below); CFROI is the ratio of gross cash flows to gross capital invested. TSR is equal to
,
where ri is the daily Datastream return index (defined as the theoretical growth in value of a share holding over a one-day period, assuming that dividends are
re-invested to purchase additional units of the stock), and d1 (d2) is the last (first) day of fiscal year t. EPS growth is equal to the change in EPS from year t - 1 to t, scaled by EPS at
time t - 1. ROA is equal to operating profit divided by total assets, while ROE is equal to net income scaled by book value of shareholders’ funds. (Median ROE is capped at 40 percent
for charting purposes. The extreme median ROE value for the Telecommunications sector is driven by observations for BT Group, in particular 2009 and 2010.) WACC is the weighted
average costs of capital defined as the cost of equity (computed using CAPM) weighted by the fraction of equity in total capital plus the after-tax cost of debt weighted by the fraction
of debt in total capital.
Co
Annual Bonus
Bonus
Annual
Salary
Salary
ROA
0.080 1.40
0.60
0.060 1.20
0.40
0.040 1.00
0.20
0.020
0.80
0.00
0.000
0.60
2003 2004 2005 2006 2007 2008 2009 2010 2011
0.40
Year
s
Annual
Annual Bonus
Bonus
Salary
Salary
TSR
ia
Share based
based
Share
Pension and
and other
other benefits
benefits
Pension
1.00
Ba
38 | www.cfauk.org
2012 2013
CFROI (%)
Year
0.80
M
Share
Share based
based
Pension and
and other
Pension
other benefits
benefits
0.100
sic
BBaa
ssicic
MM
aa
CCoo
nnss teteriraia
uumm
lsls
CCoo
nnss eer rGG
o
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eer r
ss
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rvrv
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FFinin ss
aann
cc
HHee iaialsls
aal l
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CCaa
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sst t
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GGaa
TeTe
TeTe
cchh ss
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CCoo
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UUt t
iliitlit
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0
0
Percentage
Percentage
Percentage
0%
0%
FCF (Income)
(NOPAT)
2003 2004 2005 2006RI2007
2008 2009 2010 2011
1.20
0.120
1000
1000
10%
10%
at
1.40
2000
2000
20%
20%
FCF (Cash)
2012 2013
EPS growth
WACC
0.040
0.000
Co
n
3000
3000
30%
30%
M
er
ia
at
M
4000
4000
er
40%
40%
5000
5000
sic
50%
50%
ROE
Cost of debt
0
Ba
60%
60%
400000
ls
6000
6000
70%
70%
£000
£000
Percentage
Percentage
80%
80%
ROA
Co
n
7000
7000
800000
at
90%
90%
1200000
TSR
2012 2013
Year
0.080
Year
sic
8000
8000
1600000
0
Ba
100%
100%
Panel B: Performance metrics by sector (medians)
Ba
Panel B: CEO compensation by sector
EPS growth
0.100
Notes:
Variable definitions are as follows: FCF(Cash) is defined from a capital maintenance perspective
and is equal to net operating cash flow minus net cash flow from investments; FCF(Income) is
defined from an all-inclusive per-spective and is equal to net income plus non-cash charges,
minus total capital expenditure and cash dividends; RI (NOPAT) is net operating profit after tax less
a capital charge equal to the product of book value of net assets and a firm- and time-varying
estimate of the weighted average cost of capital; CFROI is the ratio of gross cash flows to gross
capital invested. TSR is equal to , where ri is the daily Datastream return index (defined as the
theoretical growth in value of a share holding over a one-day period, assuming that dividends are
re-invested to purchase additional units of the stock), and d1 (d2) is the last (first) day of fiscal year
t. EPS growth is equal to the change in EPS from year t - 1 to t, scaled by EPS at time t - 1. ROA is
equal0.30
to oper-ating profit divided by total assets, while ROE is equal to net income scaled by book
value of shareholders’ funds. WACC is the weighted average costs of capital defined as the cost of
equity
(computed using CAPM) weighted by the fraction of equity in total capital plus the after-tax
0.20
cost of debt weighted by the fraction of debt in total capital.
FIGURE 2: MEDIAN PERFORMANCE METRICS BY SECTOR AND TIME
0.020
FIGURE 1: MEAN CEO COMPENSATION BASED ON FAIR VALUE OF EQUITY INCENTIVES GRANTED DURING THE
PERIOD PRESENTED BY TIME AND SECTOR
ROE
0.120
Percentage
Time
Time
ROA
FCF (Income)
2003
2003 2004
2004 2005
2005 2006
2006 2007
2007 2008
2008 2009
2009 2010
2010 2011
2011 2012
2012 2013
2013
Time
Time
2012 2013
Year
Percentage
2003
2003 2004
2004 2005
2005 2006
2006 2007
2007 2008
2008 2009
2009 2010
2010 2011
2011 2012
2012 2013
2013
EPS growth
2003 2004 2005 2006 2007 2008 2009 2010 2011
Year
FCF (Cash)
ROE
-0.30
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
RI (NOPAT)
ROA
-0.10
0
0
0%
0%
2012 2013
Year
-0.20
0.10
50000
1000
1000
10%
10%
0.30
-0.30
0.40
250000
2000
2000
20%
20%
£000/Percentage
£000/Percentage
Percentage
Percentage
Percentage
80%
80%
400000
300000
6000
6000
-0.10
-0.20
Percentage
Panel A: CEO compensation by time
100%
100%
Percentage
0.00
FIGURE 2: MEDIAN PERFORMANCE METRICS BY SECTOR AND TIME
CFROI (%)
FIGURE 1: MEAN CEO COMPENSATION BASED ON FAIR VALUE OF EQUITY INCENTIVES GRANTED DURING THE
PERIOD PRESENTED BY TIME AND SECTOR
0.10
www.cfauk.org | 39
sector is 20 percent; and while performance share plans
represent 72 percent of average total compensation
in the oil & gas sector, they account for less than 60
percent in the consumer goods sector.
Evidence on the metrics linking CEO compensation to
performance is reported in Tables 3 to 5. Performance
metrics are classified into three generic categories in
Table 3: accounting-based metrics (e.g., EPS, ROA, ROE,
etc.), market-based metrics (e.g., TSR), and non-financial
metrics (e.g., customer satisfaction). Consistent with
evidence reviewed in Section 7, most firms in most
years link one or more components of CEO pay to
accounting- and market-based performance, with the
former being relatively more popular: 97 percent of
firm-year observations employ at least one accounting
metric compared with 83 percent that use at least one
market-based metric. Untabulated results reveal that
accounting-based metrics are more frequently used
in short-term bonus plans whereas market-based
measures (either in isolation or combined with
accounting measures) are more commonly employed
in share-based plans. Whereas the accounting-based
category includes a variety of metrics (see Table 4),
the market-based category is dominated by TSR.
Non-financial performance metrics are less prevalent in
relative terms but are nevertheless widely employed in
absolute terms (63 percent of firm-years).
TABLE 4
The popularity of accounting metrics is consistently
high across time and sector (with the exception of oil
and gas), whereas the use of market-based measures
displays greater variation over time and across sectors.
Non-financial metrics display the highest degree of
variation across sectors, as well as a marked upward
trend over the sample period. By 2013, the majority (80
percent) of sample firms linked at least one aspect of
CEO pay to non-financial performance.
Financials
Table 4 provides more granularity for accounting-based
performance metrics. Income measures are the most
popular type of accounting measure (94 percent of
firm-years where accounting measures are employed).
TABLE 3
Performance metrics by category:
N
Accounting
Market
Non-financial
330
0.97
0.83
0.63
Basic Materials
22
0.95
1.00
0.91
Consumer Goods
22
1.00
0.45
0.41
0.40
Total sample
By industry:
Consumer Services
55
1.00
0.67
Financials
44
1.00
0.68
0.75
Health Care
22
1.00
0.95
0.86
Industrials
99
1.00
0.92
0.47
Oil & Gas
22
0.55
1.00
0.77
Technology
11
1.00
0.82
0.73
Telecommunications
11
1.00
1.00
1.00
Utilities
22
1.00
0.91
1.00
2003
30
0.97
0.67
0.53
2004
30
0.93
0.80
0.53
2005
30
0.97
0.83
0.50
2006
30
0.97
0.87
0.67
2007
30
0.97
0.87
0.63
2008
30
0.97
0.90
0.67
2009
30
0.97
0.90
0.63
By year:
2010
30
0.97
0.90
0.63
2011
30
0.97
0.83
0.67
2012
30
0.97
0.77
0.67
2013
30
1.00
0.77
0.80
Notes:
Findings are based on the sample of 30 firms and 11 years of data per firm. Information on the performance metrics used in CEO compensation contracts are collected from the
remuneration report section of firms’ published annual report and ac-counts. We focus exclusively on CEO compensation arrangements and record information separately for each
compensation component (annual bonus, deferred bonus, share options, performance share plans, etc.). Details of all contracted perform-ance measures used in determining
compensation for fiscal year t are recorded and classified into three generic categories: accounting-based metrics (e.g., EPS, FCF, ROE, residual income, etc.), market-based metrics
(e.g., TSR), and non-financial metrics (e.g., customer satisfaction).
40 | www.cfauk.org
Accounting performance metric by category:
N
Income
measures
Sales
Accounting
Returns
Cash
flows
Margins
Cost
reduction
RI
Gearing
Other
319
0.94
0.21
0.33
0.30
0.08
0.07
0.00
0.05
0.26
21
0.62
0.00
0.38
0.00
0.00
0.00
0.00
0.00
0.48
Consumer Goods
22
0.95
0.00
0.27
0.14
0.00
0.00
0.00
0.00
0.50
Consumer Services
55
1.00
0.55
0.44
0.35
0.00
0.02
0.00
0.00
0.20
44
0.82
0.45
0.50
0.07
0.25
0.45
0.00
0.23
0.57
0.05
Total sample
By industry:
Basic Materials
Health Care
22
0.91
0.32
0.14
0.41
0.64
0.00
0.00
0.00
Industrials
99
1.00
0.04
0.31
0.52
0.01
0.00
0.00
0.05
0.07
Oil & Gas
12
0.92
0.00
0.92
0.00
0.00
0.08
0.00
0.00
0.08
Technology
11
1.00
0.18
0.00
0.00
0.00
0.00
0.00
0.00
0.00
Telecommunications
11
1.00
0.27
0.00
1.00
0.00
0.00
0.00
0.00
0.00
Utilities
22
1.00
0.00
0.00
0.00
0.00
0.05
0.00
0.05
0.77
By year:
2003
29
0.93
0.14
0.28
0.17
0.00
0.10
0.00
0.03
0.31
2004
28
0.96
0.14
0.29
0.18
0.07
0.07
0.00
0.07
0.29
2005
29
0.93
0.21
0.31
0.17
0.10
0.07
0.00
0.07
0.31
2006
29
0.93
0.24
0.34
0.21
0.10
0.07
0.00
0.07
0.31
2007
29
0.93
0.21
0.38
0.24
0.07
0.07
0.00
0.07
0.31
2008
29
0.97
0.17
0.34
0.28
0.10
0.07
0.00
0.03
0.28
2009
29
0.97
0.17
0.31
0.38
0.07
0.07
0.00
0.03
0.24
2010
29
0.97
0.17
0.28
0.38
0.07
0.07
0.00
0.03
0.21
2011
29
0.93
0.28
0.31
0.38
0.10
0.07
0.00
0.07
0.24
2012
29
0.90
0.31
0.38
0.45
0.10
0.10
0.00
0.03
0.21
2013
30
0.90
0.23
0.40
0.47
0.10
0.03
0.00
0.03
0.17
Consistent with prior survey evidence (Deloitte 2010,
KPMG 2013, PwC 2013), EPS is the most commonly used
income metric. Accounting returns such as ROA and
ROE are also popular (33 percent of firm-years where
accounting measures are employed). Sales and cash
flow metrics also feature, although their incidence
varies by sector. A significant fraction of firms in the
consumer service and health care sectors employ both
metrics, while reliance on sales (cash flow) is particularly
prominent in the financials (telecommunications and
industrials) sector. Other sectors place little weight on
these metrics. Accounting-based categories such as
margins and cost reduction targets feature infrequently.
Results in Table 4 reveal firms in most sectors typically
employ between one and three accounting metrics. The
exceptions are financials (where a broader set of metrics
including income, sales, accounting returns, margins,
cost, gearing and other is employed) and to a lesser
degree firms in the health care and customer services
sectors. A notable feature of Table 4 is the absence of
accounting-based metrics that benchmark performance
against the cost of capital. In particular, residual income
and its cousins such as EVA© have failed to gain traction
despite their theoretical superiority.
Further information concerning the relative mix of
non-financial performance measures is reported in
Table 5, where metrics are grouped into four generic
categories: employee, customer, environment, and
ethics. Conditional on CEO compensation being aligned
with at least one non-financial metric, employeeand customer-based targets are the most popular
choice, followed by environmental performance and,
finally, ethics. Not surprisingly, non-financial metrics
vary by industry. For example, employee (safety) and
environmental targets feature prominently in the oil and
gas and utilities sectors, while customer-focused targets
are more common in the consumer services, financials,
telecommunications, and utilities sectors. There is some
evidence of an increasing trend in the use of employee
and environmental metrics.
Findings reported in Tables 3 and 4 confirm prior
evidence that EPS and TSR are the most popular metrics
used to align CEO compensation with firm performance.
To shed further light on the relative importance of these
two measures, we follow De Angelis and Grinstein
(2014) and estimate the proportion of total potential
performance-related compensation associated
www.cfauk.org | 41
directly with each metric. To reiterate, this analysis
measures the maximum fraction of potential future
performance-related payments linked to a given metric
rather than the fraction of realised performance-related
compensation. Findings should therefore be interpreted
as providing ex ante evidence on the relative importance
of EPS and TSR.
conditions), which on average account for a modest
proportion of total performance-related pay incentives
(Table 2 and Panel B in Figure 1). Firms in the industrials
and technology sectors are associated with the highest
compensation weight on EPS growth. There is some
evidence of an increase over the sample period in the
weight on EPS growth but the trend is not linear.
For the mean (median) firm-year in our sample
approximately 25 (four) percent of the maximum value
of performance-related compensation awardable in the
period is linked directly to EPS growth. Skewness in the
findings reflects a small set of sample firms that place
very high weight on EPS growth. The analysis suggests
that while the use of EPS growth targets is widespread
(Table 4), the total value of awardable pay linked to
EPS performance is more variable. We attribute this
variation to EPS metrics being more frequently employed
in short-term bonus plans (particularly following
the demise of share option plans with EPS vesting
The mean (median) firm-year is associated with
a 49 (32) percent compensation weight on TSR,
reflecting the dominance of equity incentives in
total performance-related pay and the fact that TSR
metrics are widely applied to the equity component of
compensation. The weight on TSR is relatively stable
over the sample period but varies considerably across
sectors. Inter-industry variation is expected given the
variation in equity incentives reported in Panel B of Figure
1. Sectors with the highest compensation weight linked to
TSR include oil and gas, health care, and basic materials.
Whether linking CEO pay closely with TSR incentivises
TABLE 5
Non-financial performance metrics by category:
N
Employee
Customer
Environment
Ethics
208
0.26
0.25
0.13
0.04
Basic Materials
20
0.45
0.00
0.00
0.00
Consumer Goods
9
0.11
0.11
0.11
0.00
Consumer Services
22
0.41
0.41
0.36
0.00
Financials
33
0.24
0.52
0.00
0.00
Health Care
19
0.00
0.00
0.00
0.00
Industrials
47
0.13
0.00
0.00
0.04
Oil & Gas
17
0.53
0.00
0.47
0.00
Technology
8
0.00
0.13
0.00
0.00
Telecommunications
11
0.00
1.00
0.00
0.00
Utilities
22
0.59
0.64
0.45
0.27
2003
16
0.19
0.31
0.00
0.00
2004
16
0.13
0.25
0.00
0.00
Total sample
By industry:
By year:
2005
15
0.20
0.27
0.07
0.00
2006
20
0.25
0.25
0.15
0.05
2007
19
0.26
0.26
0.16
0.05
0.10
2008
20
0.30
0.25
0.15
2009
19
0.32
0.26
0.16
0.11
2010
19
0.37
0.26
0.21
0.05
2011
20
0.30
0.30
0.15
0.05
2012
20
0.25
0.25
0.15
0.00
2013
24
0.29
0.17
0.17
0.00
Notes:
Findings are based on the subset of sample firm-years where CEO compensation is directly aligned with at least one non-financial performance metric.
42 | www.cfauk.org
(and to a lesser extent EPS growth) rewards value
creation appropriately is a separate question on which
our subsequent analysis aims to shed light. 25
15 CORRELATION BETWEEN
ALTERNATIVE PERFORMANCE
METRICS
This section presents evidence on the degree of
alignment between a suite of value-based performance
measures and a set of other accounting- and
market-based metrics commonly used to evaluate firm
performance and senior executive performance. The
group of value-based metrics comprises FCF, RI, and
CFROI, while the residual group of metrics consists of
TSR, ROA, ROE, and EPS growth.
15.1 SUMMARY STATISTICS FOR PERFORMANCE
METRICS
Summary statistics for all performance metrics and
components thereof are reported in Panels A and
B of Table 6. Panel A presents statistics using raw
(unadjusted) variables. The median sample firm
generates positive free cash flow and residual income.
However, median values mask considerable variation
in performance, with some firm-years associated with
large negative values (i.e., value destruction). Similarly,
while the median CFROI suggests a healthy annual
return of approximately 33 percent, considerable
variation in performance is evident. Note also that
distributions for all value-based metrics contain
extreme values that skew results and could influence
conclusions. This is particularly apparent for the
FCFCash metric where one extreme negative value
(-£39.1 billion) skews the entire distribution to the left.
(See footnote 18 for a discussion of why FCFCash is
susceptible to large negative values.) The magnitude
of this extreme value is likely to affect correlations with
other performance metrics and with measures of CEO
compensation variables, even when nonparametric
methods are used. Accordingly, subsequent results
should therefore be interpreted with this caveat in
mind. All else equal, we expect findings reported for
FCFIncome to be more reliable but for completeness we
present results using both metrics. 26
Median TSR, ROA and ROE over the sample period are
15 percent, seven percent, and 19 percent respectively.
Median core annual EPS growth is 10 percent. As
with our value creation metrics, all four variables
are characterised by extreme observations. Finally,
the median annual cost of equity (debt) estimate is
eight (five) percent over the sample period and the
resulting median WACC is 6.4 percent. While these
average values are plausible, estimation error caused
by extreme share market volatility leads to implausible
(e.g., negative) values for both the cost of equity and
WACC. Extreme cost of capital estimates feed through
into extreme values for RI via equation (3).
Panel B of Table 6 seeks to address the problem of
extreme or implausible values. For RI we replace
extreme observations or missing (negative) values
for cost of debt and tax rate (cost of equity and
book equity). For ROE, we replace two negative book
equity observations with their corresponding lagged
values.27 (Further details of the adjustment process are
available from the authors on request.) The resulting
distributions for cost of equity and WACC display
more reasonable maximum and minimum values: the
maximum (minimum) adjusted value for cost of equity
is 17.9 (0.0) percent, while the corresponding value
for WACC is 16.9 (0.1) percent. We do not winsorize
extreme values for other variables in Table 6 because
these values do not necessarily reflect measurement
error; and we do not delete outliers to preserve sample
size. Instead, we conduct the majority of subsequent
analyses using nonparametric statistical tests. We
also conduct additional robustness tests where
appropriate to assess the sensitivity of our results to
deletion of extreme observations. Nevertheless, we
stress the need for caution when interpreting statistical
associations computed using a relative small sample
size such as that employed here.
Figure 2 reports median values for performance
metrics by time (Panel A) and sector (Panel B) based
on the adjusted data reported in Panel B of Table 6.
25In additional untabulated tests we partitioned firms by their average ex ante compensation weight associated with EPS and TSR during the sample window and examined the
overall incidence of performance measure categories across those partitions. Not surprisingly, the incidence of accounting- (market-) based performance metrics is greater for
firms that attach higher ex ante compensation weight to EPS (TSR) and as such the results provide a useful validity check on the method for calculating compensation weights
proposed by De Angelis and Grinstein (2014). Findings also reveal that the popularity of accounting-based metrics (relative to market and non-financial measures) is higher for all
portfolios regardless of the ex ante weight attached to EPS. This pattern serves to further illustrate the dominance of accounting-based metrics as proxies for management and
firm performance. While the relative popularity of accounting-based metrics is consistent with these measures shielding executives from uncontrollable market-level factors, it also
increases the risk of gaming and myopic behaviour highlighted in section 8.
26Closer inspection reveals this observation is not a data error. In untabulated tests where we trim or winzorize this value, the resulting distribution for FCFCash is more consistent with
that for FCFIncome.
27ROE for BT Group in 2010 remains extreme (724 percent) even after making this adjustment and as a result we treat this value as missing in subsequent tests.
www.cfauk.org | 43
TABLE 6
Panel A: Raw data
N
Mean
St. dev.
Min
Median
FCFCash
Variable
330
-70805
3923793
-39100000
168979
11000000
Max
FCFIncome
330
407383
1300489
-6906977
149300
9514000
RI
305
728336
1254629
-3191199
281065
7464298
CFROI
330
0.331
0.989
-4.557
0.327
7.302
TSR
330
0.160
0.349
-0.813
0.146
1.822
ROA
305
0.073
0.088
-1.135
0.068
0.278
ROE
305
0.212
0.786
-9.472
0.187
2.871
EPS growth
330
0.356
2.933
-0.983
0.102
43.975
Cost of equity
330
0.076
0.044
0.000
0.079
0.179
Cost of Debt
330
0.034
0.021
0.005
0.045
0.071
WACC (CAPM)
306
0.062
0.052
-0.624
0.064
0.169
Mean
St. dev.
Min
Panel B: Adjusted data
Variable
N
Median
Max
11000000
FCF
330
-70805
3923793
-39100000
168979
FCFIncome
330
407383
1300489
-6906977
149300
9514000
RI
330
686629
1247213
-3299770
268398
7464298
CFROI
286
0.514
0.713
-1.916
0.376
4.471
TSR
330
0.160
0.349
-0.813
0.146
1.822
Cash
ROA
330
0.071
0.058
-0.172
0.065
0.278
ROE
330
0.282
0.915
-9.472
0.182
11.083
43.975
EPS growth
330
0.356
2.933
-0.983
0.102
Cost of equity
330
0.076
0.044
0.000
0.079
0.179
Cost of Debt
330
0.034
0.021
0.005
0.045
0.071
WACC (CAPM)
330
0.064
0.034
0.001
0.064
0.169
Notes:
Variable definitions are as follows: FCFCash is defined from a capital maintenance perspective and is equal to net operating cash flow minus net cash flow from investments;
FCFIncome is defined from an all-inclusive perspective and is equal to net income plus non-cash charges, minus total capital expenditure and cash dividends; RI is net operating
profit after tax less a capital charge equal to the product of book value of net assets and a firm- and time-varying estimate of the weighted average cost of capital (see below); CFROI
is the ratio of gross cash flows to gross capital invested. TSR is equal to refer TSR equation on page 32, where ri is the daily Datastream return index (defined as the theoretical growth
in the value of a shareholding over a one-day period, assuming that dividends are re-invested to purchase additional units of the stock), and d1 (d2) is the last (first) day of fiscal
year t. EPS growth is equal to the change in EPS from year t - 1 to t, scaled by EPS at time t - 1. ROA is equal to operating profit divided by total assets, while ROE is equal to net income
scaled by book value of shareholders’ funds. WACC is the weighted average costs of capital defined as the cost of equity (computed using CAPM) weighted by the fraction of equity in
total capital plus the after-tax cost of debt weighted by the fraction of debt in total capi-tal. Panel A presents statistics using raw (unadjusted) variables. Panel B reports results using
adjusted values of RI and ROE that account for extreme or implausible observations.
The first chart in Panel A reports time-series trends
for value-based metrics (FCF, RI and CFROI). With the
exception of the FCFCash metric, all measures reveal
a dip in performance that coincides with the onset of
the financial crisis in 2007/2008, followed by a rebound
in 2009 or thereafter. Similar patterns are also evident
in the second chart in Panel A that reports results for
TSR, ROA, ROE and EPS growth. The negative spike
around 2007 to 2009 is particularly apparent for TSR,
reflecting the general decline in global stock markets
during this period.
The final chart in Panel A of Figure 2 presents the time
trend for WACC and its components. A significant
decline in WACC is evident from around 10 percent in
2007 to less than six percent from 2009 onwards.
The decline is driven primarily by a reduction in the
cost of equity, although a slight downward trend in
44 | www.cfauk.org
the cost of debt is also apparent between 2007 and
2010. Results suggest that lower cost of capital (rather
than growth in underlying business cash flows) was
the primary driver of value creation improvements
between 2009 and 2011, and that these gains may
have reflected macroeconomic factors beyond
management’s control.
Panel B of Figure 2 compares median performance
by sector. Significant variation in value creation is
evident, with basic materials, telecommunications,
and heathcare demonstrating particularly strong
performance. Financials also display high RI, although
this is likely to be driven by structural differences in
the way invested capital is measured for banks and
other financial institutions relative to non-financial
firms. Significant industry variation in measured
performance is also apparent for TSR, ROA, ROE and
computed using 11 years of data per firm. Results are
broadly consistent using the two approaches although
some notable differences are apparent. The majority of
correlations in both panels are statistically significant at
the 10 percent level or better.
EPS growth, consistent with structural differences in
factors such as asset utilisation, operating margins,
and accounting treatments.
Collectively, results reported in Figure 2 highlight the
importance of benchmarking performance evaluations
by industry and time-period norms to better isolate the
components of performance over which management
exercise material control.
Several important conclusions emerge from Table
7. First, pairwise correlations between the group of
value-based metrics are positive (with the exception of
FCFCash and CFROI). For example, FCFIncome and RI display
correlation coefficients ranging from 0.43 (Panel A)
to 0.39 (Panel B); FCFIncome and RI also exhibit strong
positive correlations with CFROI in both Panel A using
pooled data (0.43 and 0.32, respectively) and Panel B
based on mean firm-specific time-series correlations
(0.25 and 0.21, respectively). Correlations based on
FCFCash are uniformly weaker, reflecting the impact of
an extreme value in the FCFCash distribution. Collectively,
results are consistent with all three value-based
metrics capturing a similar underlying value-creation
construct measured over a 12-month window. With
no correlation coefficients exceeding 0.5, however,
findings nevertheless suggest these metrics capture
different aspects of the value creation phenomenon.
The low level of alignment in absolute terms highlights
the importance of performance metric selection even
when a consistent value-based perspective is adopted.
15.2 CORRELATION BETWEEN PERFORMANCE
MEASURES
This section reports evidence on the degree of
alignment between alternative measures of periodic
performance. Specifically, we examine the degree of
association between alternative value-based metrics,
and between value-based metrics and other measures.
Table 7 reports pairwise nonparametric (Spearman)
correlations. We focus on Spearman correlations
to mitigate the impact of extreme observations
and we scale RI and FCF metrics by lagged market
capitalisation to eliminate the confounding effects
of firm size that would otherwise induce spurious
positive correlation between these unscaled measures,
and to ensure comparability with other growth- and
return-based measures. Panel A presents correlations
computed for the pooled sample while Panel B reports
the mean of individual firm-level correlation coefficients
TABLE 7
Scaled FCF (Cash)
Scaled FCF (Income)
Scaled RI (NOPAT)
CFROI
Panel A: Pooled sample
Scaled FCFCash
1.00
Scaled FCF
0.24
1.00
0.13
0.43
1.00
Income
Scaled RI
CFROI
-0.04
NS
0.43
0.32
1.00
TSR
-0.08
NS
0.13
0.16
0.10
ROA
0.13
0.16
0.33
0.34
ROE
0.10
0.22
0.49
0.45
EPS growth
0.09
0.24
0.17
0.15
NS
NS
Panel B: Mean of firm-level correlations
Scaled FCFCash
1.00
Scaled FCF
0.27
1.00
Income
0.14
0.39
1.00
CFROI
Scaled RI
-0.09
0.25
0.21
1.00
TSR
-0.06
0.08
0.14
0.22
ROA
0.05
0.23
0.58
0.39
ROE
0.06
0.19
0.52
0.29
EPS growth
0.10
0.18
0.13
0.13
Notes
See Table 6 for variable definitions. Panel A reports correlations computed using the cross-sectional and time-series pooled sample. Panel B reports the mean value of firm-specific
correlations computed using 11 observations per firm. NS indicates correlations that are not significant at the 0.10 level or better.
www.cfauk.org | 45
FCFIncome and RI, respectively, in Panel B). Despite the
dysfunctional investment behaviour that ROA and ROE
can induce, these results suggest both measures are
capable of capturing a significant degree of variation in
economic returns.
The second conclusion emerging from Table 7 is that
the two dominant performance metrics employed
in executive compensation contracts (i.e., EPS
growth and TSR) exhibit weak associations with all
three value-based metrics. For example, correlation
coefficients reported in Panels A and B of Table 7
between TSR and FCFIncome, and between TSR and
RI do not exceed 0.16. Similar results are evident for
correlations between EPS growth and RI, and between
EPS growth and CFROI. Meanwhile, correlations
between FCFCash and EPS do not exceed 0.1, while
corresponding values for TSR are negative. Even the
highest correlations reported between FCFIncome and
EPS (0.24, Panel A) and CFROI and TSR (0.22, Panel
B) are modest in absolute terms. Collectively, these
results cast serious doubt on the extent to which TSR
and EPS reflect economic returns to capital providers
during the reporting period and hence call into question
firms’ reliance on these metrics as key determinants of
CEO compensation.
We further explore the link between alternative
measures of periodic performance using the following
ordinary least squares (OLS) regression to assess the
power of commonly employed performance metrics to
explain variation in value creation:
Value Creation itk = ϕ 0 + ϕ1TSR it + ϕ 2 EPSit + ϕ 3 ROI itp + εit
where Equation (18) is one of our three value-based
performance metrics (k = FCF, RI, and CFROI), TSR
and EPS are as previously defined, and ROIp is one
of our two return on investment metrics (p = ROA or
ROE). Model summary statistics for equation (18) are
reported in Table 8. Panel A presents results based
on a single pooled regression while Panel B presents
mean values computed using firm-level regressions
estimated with 11 years of data per firm. Results are
in line with those reported in Table 7. Results for the
pooled regression models reported in Panel A reveal
very low explanatory power of commonly employed
performance metrics for value creation: the highest
R-squared value is only 16 percent (model 3 for RI) and
in most cases R-squareds do not exceed five percent.
While firm-level regressions reported in Panel B are
associated with higher R-squared values, at best
the vector of non-value-based metrics explain only
The third notable finding in Table 7 is that traditional
accounting return on investment metrics such as ROA
and ROE exhibit relatively strong and robust positive
correlations with all three value-based metrics (with
the exception of FCFCash). For example, correlation
coefficients for ROE range from 0.22 to 0.45 for FCFIncome
and CFROI, respectively, in Panel A (0.19 to 0.52 for
FCFIncome and RI, respectively, in Panel B). Similarly,
correlations for ROA range from 0.16 to 0.34 for FCFIncome
and CFROI, respectively, in Panel A (0.23 to 0.58 for
TABLE 8
CFROI
Scaled RI
Scaled FCFCash
Model 1
Model 2
Model 3
Model 4
Model 5
EPS growth
-0.008
-0.012
0.000
-0.001
**
0.007
TSR
-0.045
0.045
0.011
0.031
**
-0.086
Scaled FCFIncome
Model 6
Model 7
Model 8
***
0.006
0.000
0.000
**
-0.062
0.01
0.015
Panel A: Pooled regressions
ROA
2.185
0.497
***
ROE
Constant
*
0.048
0.354
Adjusted R2
0.03
***
0.495
0.01
0.616
***
0.012
***
0.024
**
0.16
0.053
0.012
0.04
-0.01
0.027
0.06
0.03
0.024
0.01
*
0.031
***
0.01
Panel B: Means of firm-level regressions
EPS growth
0.412
0.448
0.006
TSR
-0.023
-0.044
-0.015
ROA
1.563
ROE
Constant
Adjusted R2
1.515
0.819
Scaled FCF (Cash)
Overall the findings reported in Tables 7-9 cast doubt on
the legitimacy of performance metrics commonly used
in executive compensation contracts. Results suggest
that motivating senior executives to grow EPS and TSR
does not necessarily generate economic returns to
capital providers due to poor alignment between these
metrics and measures of periodic value creation.
16 EXECUTIVE COMPENSATION AND
VALUE CREATION
Evidence presented in section 14 identifies EPS growth
and TSR as the most commonly employed metrics
Scaled FCF (Income)
Scaled FCFCash
1.00
Scaled FCFIncome
0.35
1.00
Scaled RI
0.32
0.65
CFROI
-0.01
TSR
-0.20
0.01
ROA
0.16
0.20
ROE
0.16
-0.06
NS
0.06
1.00
1.00
Scaled RI
0.37
0.71
1.00
0.31
0.28
0.026
CFROI
-0.06
-0.007
-0.065
**
-0.063
**
0.001
0.002
TSR
-0.21
-0.04
ROA
0.17
0.19
ROE
0.18
0.346
0.164
0.352
0.334
0.01
0.014
0.007
0.001
0.014
0.006
0.50
0.48
0.61
0.60
0.41
0.42
0.40
0.41
-0.10
0.10
NS
0.50
0.48
NS
0.40
0.012
0.150
1.00
NS
0.33
Scaled FCFIncome
**
-0.746
0.01
Scaled FCFCash
0.057
***
0.29
NS
0.33
NS
**
0.380
CFROI
1.00
0.32
0.072
***
Scaled RI (NOPAT)
Panel A: Pooled sample, three-year window
-0.003
Notes:
See Table 6 for variable definitions. Panel A reports regression coefficients and summary statistics estimated using the cross-sectional and time-series pooled sample. Panel B
reports the mean value of coefficient estimates and model summary statistics from firm-specific regressions estimated using 11 observations per firm. ***, ** and * indicates
significance at the one, five and 10 percent levels, respectively.
46 | www.cfauk.org
TABLE 9
growth are annual values compounded over three-year
windows). Correlations among all value-based
metrics when measured over multi-year periods
are qualitatively similar or larger in magnitude to
those reported in Table 7. In contrast, associations
between value-based metrics and both TSR and EPS
growth are statistically indistinguishable from zero
at conventional level of significance. These findings
provide even stronger evidence than that reported in
Tables 7 and 8 of a disconnect between value creation
and traditional performance metrics used in executive
compensation contracts.
0.47
NS
0.10
NS
Panel B: Pooled sample, three-year window
0.010
**
Findings reported in Tables 7 and 8 are based on
performance measured over a 12-month period.
To assess the robustness of these findings to the
length of the performance measurement window, we
repeat the correlation analysis based on performance
measured over two- and three-year intervals. Results
are reported in Table 9. Panel A reports pooled
correlations based on two-year non-overlapping
performance windows (i.e., 2003 and 2004, 2005 and
2006, 2007 and 2008, etc.). All performance measures
are recomputed for the corresponding two-year period
(TSR and EPS growth are annual values compounded
over two-year windows). Panel B reports pooled
correlations based on three-year non-overlapping
performance windows (i.e., 2003-2005, 2006-2008,
etc.). All performance measures are recomputed for
the corresponding three-year period (TSR and EPS
EPS growth
0.142
***
*
***
***
60 percent of the variation in periodic value creation
(models 3 and 4 in Panel B for RI) and more typically
the explanatory power is around 50 percent. Further,
ROE and ROA contribute the majority of explanatory
power: coefficient estimates on TSR and EPS are low in
magnitude and statistically indistinguishable from zero
in many cases.
**
EPS growth
-0.03
NS
NS
0.08
NS
0.28
0.36
NS
-0.08
1.00
-0.12
NS
0.49
0.44
NS
0.13
0.48
NS
0.10
NS
Notes
See Table 6 for variable definitions. Panel A reports pooled correlations based on two-year non-overlapping performance windows (i.e., 2003 and 2004, 2005 and 2006, 2007 and
2008, etc.). All performance measures are recomputed for the corre-sponding two-year period (TSR and EPS growth are annual values compounded over two-year windows).
Panel B reports pooled correlations based on three-year non-overlapping performance windows (i.e., 2003-2005, 2006-2008, etc.). All per-formance measures are recomputed for
the corresponding three-year period (TSR and EPS growth are annual values com-pounded over three-year windows). NS indicates correlations that are not significant at the 0.10
level or better.
www.cfauk.org | 47
linking executive compensation to firm performance,
while results presented in section 15 highlight the weak
association between these contracted performance
metrics and established measures of economic
returns to capital providers. An open question is the
extent to which executive remuneration correlates
with fundamental value creation to capital providers,
as opposed to short-term measures of performance
whose link with value creation is more questionable.
in total CEO wealth, defined as salary plus realised
bonus plus the grant date fair value of shares awarded
during the period plus the change in the market value of
CEO direct equity holdings. For the Realised and Granted
approaches Table 10 reports separate correlations for
total pay (salary plus bonus plus equity incentives plus
pensions and other), total variable pay (bonus plus
equity incentives), and equity-only incentives.
Findings reported in Panel A based on pooled
correlations reveal the following insights. With the
exception of ROE and CFROI (total realised and granted),
CEO compensation correlates positively with firm
performance regardless of the specific metric used.
Findings suggest that efforts by UK regulators and
governance activists over the last two decades to align
executive pay and corporate performance have been
at least partially successful. Nevertheless, correlations
are generally low in absolute terms, suggesting a
weak link between rewards to senior executives
and aspects of corporate success as reflected in a
range of well-established performance metrics. For
example, the highest correlation in Panel A is 0.29
(EPS growth with total granted variable pay). These
findings are consistent with both extant academic
evidence highlighting statistically significant but
To shed light on this question Table 10 reports
correlations between annual CEO pay and alternative
measures of periodic performance. Consistent with
previous analyses, we report Spearman correlations
estimated using the pooled sample (Panel A) as well
as mean firm-level correlation coefficients estimated
using 11 years of data per firm. Findings are presented
for three alternative approaches to measuring CEO
compensation. The first approach (Realised) measures
the equity-based component of pay using the realised
value of shares exercised during the period (as reported
in the remuneration report). The second approach
(Granted) measures the equity-based element of pay
using the grant date fair value of shares awarded (but
not necessarily vested) during the period. The third
approach (CEO wealth) measures the periodic change
TABLE 10
Realised
Granted
Total
Total variable
Equity
Total
Total variable
Equity
Total wealth
Scaled FCFCash
0.10
0.07
0.02
0.06
0.02
-0.06
-0.03
Scaled FCF
Panel A: Pooled correlations
0.21
0.25
0.19
0.20
0.26
0.05
0.18
Scaled RI
0.12
0.15
0.14
0.11
0.21
0.12
0.10
CFROI
-0.01
0.03
0.06
-0.03
0.03
0.04
0.11
TSR
0.13
0.16
0.17
0.13
0.19
0.11
0.20
Income
ROA
0.04
0.07
0.12
0.00
0.04
0.01
0.17
ROE
-0.06
-0.03
0.03
-0.10
-0.02
-0.04
-0.01
0.18
0.20
0.20
0.22
0.29
0.13
0.16
0.09
0.19
0.09
-0.05
-0.03
EPS growth
Panel B: Mean of firm-level correlations
Scaled FCFCash
0.20
0.16
Scaled FCF
0.25
0.27
0.15
0.29
0.29
0.01
0.19
0.18
0.19
0.20
0.18
0.24
0.20
0.26
CFROI
-0.03
0.01
0.05
-0.01
0.06
0.09
0.14
TSR
-0.04
-0.01
0.02
0.01
0.11
0.16
0.14
ROA
0.02
0.07
0.13
0.07
0.20
0.18
0.19
Income
Scaled RI
ROE
0.05
0.09
0.17
0.05
0.16
0.15
0.18
EPS growth
0.04
0.04
0.03
0.19
0.22
0.10
0.04
Notes:
See Table 6 for variable definitions. Findings are reported for three alternative approaches to measuring CEO compensation. The first approach (columns 2-4) is based on the realized
value of equity-based incentives exercised during the period (as reported in the remuneration report). The second approach (columns 5-7) measures equity incentives based on the
grant date fair value of shares awarded (but not vested) during the period. The third approach (final column) measure the change in total CEO wealth, defined as salary plus realized
bonus plus grant date fair value of shares awarded during the period plus the change in the market value of CEO direct equity holdings. For the realized and granted approaches,
we report results for total compensation (salary plus bonus plus equity incentives plus pensions and other), total variable pay (bonus plus equity incentives), and equity incentives.
Panel A reports correlations computed using the cross-sectional and time-series pooled sample. Panel B reports the mean value of firm-specific correlations computed using 11
observations per firm.
48 | www.cfauk.org
economically weak association between CEO pay and
firm performance, and concern raised by governance
activists and the financial media about the perception
of pay without performance. Of particular relevance
to this study, the magnitude of the association
between CEO compensation and our portfolio of value
creation proxies is limited. For example, correlations for
FCFIncome are in the region of 0.2 whereas comparable
associations with RI range between 0.1 and 0.2.
Meanwhile, correlations based on FCFCash and CFROI
are negligible. Regardless of the specific measure of
value creation used and the different approaches used
to measure CEO pay, these results suggest that much
of the variation in compensation payments to CEOs of
FTSE-100 firms does not appear to reflect differences in
established measures of value creation.
Reflecting the widespread use of performance
conditions linked to TSR and EPS growth, findings
reported in Panel A document robust positive
associations between these two metrics and all
elements of CEO pay (total, variable, and equity
incentives) using both realised and granted measures
of CEO compensation. The change in total CEO wealth
during the period (i.e., including the value of direct share
holdings) also correlates positively with EPS (0.16) and
TSR (0.20). In most cases the correlation coefficients
for EPS and TSR are statistically indistinguishable from
(larger than) those reported for FCFIncome and RI (FCFCash
and CFROI). In contrast, the association between pay
and traditional return on investment metrics such as
ROA and ROE is typically low.
Results presented in Panel B of Table 10 based on
the mean coefficients from firm-specific time-series
correlations lead to similar conclusions insofar as no
performance metric yields a correlation coefficient
above 0.29 for either the change in total CEO wealth
or any element of CEO pay (total, variable, and equity
incentives) measured using either realised or granted
estimates of CEO compensation. In contrast with the
findings in Panel A, correlations based on FCFIncome
and RI are significantly larger than those documented
for TSR and EPS in a number of cases. In relative terms,
therefore, these firm-level correlations suggest that
CEO rewards are linked more closely to certain value
creation measures. In absolute terms, however, the
message is a consistent one across the two panels:
the degree of association between CEO pay and returns
to all capital providers appears low, with at best a 20
to 30 percent correlation between compensation and
periodic value creation.
We assessed the robustness of results reported in
Table 10 by repeating the analysis using two- and
three-year non-overlapping performance windows.
Performance metrics are as defined in Table 9 while
aggregate compensation variables are defined as
annual CEO pay cumulated over the corresponding twoand three-year intervals. Results are similar to those
presented in Table 9. Specifically, while cumulative
CEO pay displays a material positive association with
value creation over these multi-year windows, between
50 and 60 percent of the variation in compensation
(regardless of specific definition) is unrelated to each
value-based proxy. Correlation coefficients between
cumulative CEO pay and both TSR and EPS growth over
these multi-year windows are similar to those reported
in Table 10.
Collectively the results reported in this section provide
a degree of comfort but also create cause for concern.
On the positive side, findings reveal a robust material
positive association between CEO pay and two
measures of periodic value creation (RI and FCF) that
have strong theoretical support. The correlations for RI
and FCF are at least as strong as those documented
for TSR and EPS using pooled tests, and in some cases
are significantly more pronounced than EPS and TSR
based on firm-specific correlations. These findings
suggest that current CEO pay structures incentivise
and reward important aspects of value creation (even
though the specific performance metrics used in
executive contracts are not directly aligned with value
creation in many cases). More troubling, however,
is the evidence that (i) a large fraction of CEO pay
appears unrelated to periodic value creation and (ii)
key aspects of compensation consistently correlate
with performance metrics such as TSR and EPS growth
whose theoretical link with value creation is fragile. On
the basis of these findings we conclude that while UK
compensation practices have come a long way since
Sir Richard Greenbury published his landmark report
in1995, the journey is far from complete. Note also that
since our analysis focuses on the largest London Stock
Exchange-listed firms that tend to follow best-practice
guidelines most assiduously, our findings likely reflect
an upper bound on the magnitude of the link between
executive pay and fundamental value creation. We
therefore view the issue of performance metric
www.cfauk.org | 49
choice in executive compensation arrangements as
work-in-progress.
17 SUPPLEMENTARY ANALYSIS
Theory and evidence highlights how EPS performance
conditions can lead executives to engage in gaming
and other dysfunctional behaviour. A natural question
given the prevalence of EPS performance conditions in
our sample is whether these targets cause FTSE-100
executives to take decisions that threaten returns to
capital providers. This section explores the impact
of EPS performance conditions in three settings. We
begin by examining the link between EPS growth
and compensation plan design conditional on the
level of return on invested capital (ROIC) relative to
cost of capital (WACC), followed by analyses of share
repurchase behaviour and earnings quality conditional
on the compensation weight attached to EPS growth.
It is important to stress that due to our small sample
size, the following analyses should be interpreted as
providing qualitative evidence rather than statistically
rigorous conclusions.
17.1 VALUE DESTRUCTION
Following Mauboussin (2006), we partition firm-year
observations into those where ROIC > WACC and those
where ROIC < WACC, and then examine EPS growth. The
numerator in the ROIC ratio is equal to net operating
profit after tax (NOPAT), defined as EBIT × (1 – Tax
rate) with EBIT equal to earnings before interest and
tax (WC18191) and Tax rate equal to (WC08346); the
denominator is equal to Net Fixed Assets (WC02501)
plus Current Assets (WC02201) minus Current Liabilities
(WC03101) minus Cash (WC02003). High EPS growth is
value destroying and leads to a lower price-earnings
TABLE 11
EPS partition
N
ratio where ROIC < WACC. An important question
is whether CEO compensation contract design
encourages EPS growth in general and in particular
where ROIC < WACC.
interpretation, the median price-earnings (enterprise
value-to-EBITDA) ratio for the high EPS growth portfolio
in Panel B is significantly lower than the corresponding
rate for the low EPS growth portfolio.
Results reported in Panel A of Table 11 provide
qualitative evidence that EPS performance conditions
in executive compensation contracts influence EPS
growth when ROIC > WACC. For example, a higher
incidence of EPS-based performance metrics and a
greater compensation weight on EPS performance
is apparent for the high EPS growth portfolio. In this
scenario, use of EPS performance conditions is more
likely to be aligned with value creation. Note, however,
that differences in EPS incidence and weight are not
statistically significant at conventional levels and as
such the impact of explicit EPS performance targets is
uncertain when ROIC > WACC.
An additional result worthy of note in Table 11 is the
high overall reliance on EPS performance conditions
when ROIC < WACC regardless of realised EPS growth.
The high absolute incidence of EPS incentives (> 60
percent of cases) where ROIC < WACC is troubling.
Results suggest that the ubiquitous nature of EPS
performance conditions coupled with the sticky nature
of compensation contract design is problematic insofar
as firms are unable switch off EPS growth incentives
when conditions demand.
Panel B reports results for firm-years where ROIC <
WACC, again partitioned into high and low EPS growth
portfolios. If the use of EPS-based targets motivates
executives to take value-destroying decisions we
would expect reliance on EPS performance metrics to
be greater in the high EPS growth portfolio. Findings
provide some support for this view. CEO compensation
contracts for observations in the high EPS growth
portfolio are associated with both a statistically
higher incidence of EPS performance conditions and
a statistically larger median weight on EPS targets.
(The mean compensation weight on EPS is also larger
in the high EPS growth partition although differences
are not statistically significant.) These findings support
for claims that linking compensation outcomes to
EPS growth can encourage management to engage
in value-destroying behaviour. Consistent with this
Median
Median
P/E
EV/EDITDA
EPS Compensation weight:
EPS incidence
Mean
Median
Panel A: ROIC > WACC
High EPS growth
124
16.16
14.48
0.79
0.29
0.11
Low EPS growth
124
15.16
14.01
0.78
0.24
0.04
No
No
No
No
No
Statistically significant:
Panel B: ROIC > WACC
High EPS growth
41
13.76
10.81
0.78
0.23
0.05
Low EPS growth
41
16.38
14.73
0.66
0.18
0.00
Yes
Yes
Yes
No
Yes
Statistically significant:
Notes:
Return on capital invested (ROIC) is equal to net operating profit after tax (NOPAT) scaled by invested capital. Statistical significant is assessed using a one-tailed Wilcoxon
two-sample test. Firm-years are first partitioned on the basis of ROIC relative to the weighted average cost of capital (WACC). The resulting two subsamples are then partitioned by
median EPS growth. Statistical significance is assessed using a one-tailed Wilcoxon two-sample test. P/E is the price-earnings ratio com-puted four months after the balance sheet
date. EV/EBITDA is the enterprise value-to-EBITDA ratio computed four months after the balance sheet date, where EV is equal to the market value of equity plus the book value of debt.
50 | www.cfauk.org
17.2 SHARE REPURCHASE ACTIVITY
An additional concern over the widespread use of
EPS conditions is that such targets create incentives
for management to favour share buybacks that
mechanically increase EPS but which may not be value
enhancing in the long run (Bens et al. 2002, Hribar et
al. 2006, Young and Yang 2011). To explore this concern
we partition our sample on the basis of the ex ante
compensation weight on EPS and then test whether
TABLE 12
EPS portfolio
Repurchase activity:
N
Incidence
High EPS weight portfolio
163
0.22
0.010
Low EPS weight portfolio
107
0.16
0.007
Yes
No
Statistically significant:
Mean yield
Notes:
Firm-years are partitioned into three categories (high, moderate and low) according to
the weight on EPS growth computed using the method from De Angelis and Grinstein
(2014). The incidence of share repurchase activity is the fraction of firm-years in the
corresponding portfolio that repurchase shares in the corresponding fiscal year.
Mean yield is the value of shares repurchased during the fiscal year scaled by market
capitalization, averaged across all observations in the corresponding portfolio.
Statistical significance is assessed using a one-tailed Wilcoxon two-sample test.
repurchase activity varies across high and low EPS
weight partitions. Results reported in Table 12 provide
some support for the view that EPS performance
conditions encourage buybacks. For example, the
incidence of buybacks is almost 1.5 times greater
among firms in the high EPS incentive weight portfolio:
repurchases occur in 22 percent of firm-years among
the high weight sample compared with just 16 percent
of firm-years in the low EPS weight sample (difference
significant at ten percent level using a one-tailed test).
Similarly, the repurchase yield (aggregate value of
shares repurchased during the fiscal year scaled by
beginning-of-period market capitalisation) is 42 percent
higher for the high EPS weight portfolio, although the
difference is not statistically significant at conventional
levels. These results provide qualitative support for
claims that EPS performance conditions encourage
share buybacks aimed at increasing EPS regardless of
whether or not they create value for shareholders.
17.3 EARNINGS MANAGEMENT
Research highlights how performance-related
compensation arrangements can create powerful for
incentives for management to manipulate reported
earnings. All else equal, greater use of earnings-based
performance metrics such as EPS in executive
compensation contracts has been linked to a higher
propensity for earnings management behaviour. It
is an empirical question whether reliance on EPS
performance conditions in CEO compensation
contracts is associated with opportunistic
accounting choices designed to maximise short-term
compensation outcomes. We explore this question
by partitioning firm-year observations according to
the compensation weight on EPS and then testing for
differences in earnings management behaviour across
high and low EPS weight portfolios.
Our proxies for earnings management are based on the
discretionary accrual model developed by Jones (1991)
and implemented using the following cross-sectional
OLS regression estimated by year and industry group:
ACCit = γ 0 + γ1ΔREVit / TAit−1 + γ 2 PPEit / TAit−1 + εit
where, ACC is total operating accruals, equal to the
change in non-cash working capital minus depreciation
and amortization, REV is the change in total revenue,
TA is total assets, and subscripts i and t represent firms
and time, respectively. The residuals ( ) from equation
(19) represent the portion of total accruals not explained
by drivers of underlying economic activity. We
construct two proxies for earnings management based
on the residuals from equation (19). Our first earnings
management proxy is the signed residual ( ). All else
equal, we expect accounting manipulation to result in
income-increasing accounting choices on average, as
reflected in more positive values of .
A fundamental property of accounting accruals is
that overstatements (understatements) made in one
period inevitably unwind in future periods leading to
compensating understatements (overstatements). This
www.cfauk.org | 51
reversing property has led academics to focus on the
absolute value of periodic accruals as an alternative
measure of earnings management: high absolute
discretionary accrual activity may capture both
earnings management in the current period as well
as the reversal of manipulations undertaken in prior
periods. Accordingly, we use the absolute magnitude
of the residual from equation (19) (| |) as a second
measure of earnings management.
TABLE 13
Panel A:
Signed discretionary accruals
EPS portfolio
N
Mean
Median
High EPS weight portfolio
159
0.00
0.00
Low EPS weight portfolio
97
-0.02
-0.01
Yes
No
Statistically significant:
Panel B:
Absolute discretionary accruals
EPS portfolio
N
Mean
Median
High EPS weight portfolio
159
0.07
0.04
Low EPS weight portfolio
97
0.07
0.05
Statistically significant:
No
No
Notes:
Firm-years are partitioned into three categories (high, moderate and low) according to
the weight on EPS growth computed using the method from De Angelis and Grinstein
(2014). Signed and absolute discretionary accruals reported in panel A and B are scaled
by lagged total assets. Discretionary accruals are computed using a cross-sectional
version of the model proposed by Jones (1991), estimated separate for each
industry-year combination. Statistical significance is assessed using a one-tailed
Wilcoxon two-sample test.
Average values for signed and absolute discretionary
accruals partitioned by EPS compensation weight are
reported in Panels A and B of Table 13, respectively.
Results using signed discretionary accruals provide
suggestive evidence consistent with earnings
management activity. Both mean and median
discretionary accruals are more positive in the high
EPS weight portfolio, although the difference in
medians is not significant at conventional levels. No
significant difference is also evident across high and
low EPS weight portfolios in Panel B of Table 13 for
absolute discretionary accruals. Overall, the results
in Table 13 suggest either that EPS performance
targets do not create incrementally powerful earnings
management incentives or that our proxies for earnings
management are too noisy to detect predicted effects
(Dechow et al 1995).
52 | www.cfauk.org
18 ALIGNMENT BETWEEN
PERFORMANCE MEASURES AND
KPis
An important goal of executive incentive schemes is to
encourage CEOs to focus on aspects of performance
that link directly with their firm’s strategic objectives.
Information disclosed in firms’ annual report and
accounts on corporate strategy and business model
by UK-listed firms provides insights into firm-specific
factors identified as core drivers of business success.
Key performance indicators (KPIs) represent the
bridge between corporate objectives and strategy
implementation. To the extent the set of KPIs disclosed
by management in the annual report and accounts
are reasonable and controllable by management, one
might expect to observe a high degree of overlap
between these metrics and the performance measures
employed in executive compensation contracts. This
section provides descriptive evidence on the extent of
this linkage.
Table 14 presents data on KPIs disclosed in firms’
annual report and accounts, classified into accounting,
market, and non-financial categories. The first row
reports results for the pooled sample. Conditional on a
firm disclosing information about KPIs in a given fiscal
year, findings highlight the importance of accounting
and non-financial measures relative to market metrics.
Income-based measures are the most popular
accounting KPI, followed by sales and cash flows.
Overall, 100 percent of disclosers specify at least one
accounting-based KPI. Corresponding frequencies for
market and non-financial metrics are 29 percent and
82 percent, respectively. Comparing this evidence with
information on the performance metrics that determine
CEO pay (see Table 3) yields several conclusions.
First, firms often elucidate strategy and business
model execution using accounting information,
although the direction of causality is unclear (i.e., do
accounting numbers drive strategic thinking or do
accounting metrics represent the language of strategy
implementation?).
Second and notwithstanding the alignment between
accounting performance measures and KPIs, results
suggest a material disconnect between the metrics
purported to drive business success and the
measures used to incentivise and reward executives.
For example, while only 29 percent of firms refer to
TABLE 14
Accounting-based metrics:
Income
measures
Sales
Accounting
Returns
Cash
flows
Margins
Cost
reduction
Residual
income
Gearing
Other
Market
Nonfinancial
0.79
0.57
0.38
0.49
0.29
0.17
0.00
0.13
0.38
0.29
0.82
Basic Materials
1.00
0.00
0.50
0.36
0.00
0.50
0.00
0.50
0.93
0.93
0.93
Consumer Goods
0.70
0.70
0.60
0.60
0.20
0.00
0.00
0.60
0.20
0.00
0.90
Consumer Services
0.94
0.94
0.26
0.37
0.37
0.09
0.00
0.03
0.37
0.00
0.69
Financials
0.69
0.28
0.56
0.13
0.56
0.03
0.00
0.00
0.56
0.47
0.78
Health Care
1.00
0.93
0.07
0.47
0.13
0.00
0.00
0.00
0.00
0.60
0.13
0.90
Total sample
By industry:
Industrials
0.70
0.67
0.64
0.72
0.40
0.19
0.00
0.15
0.34
0.09
Oil & Gas
0.38
0.06
0.00
0.63
0.00
0.63
0.00
0.19
0.00
0.81
1.00
Technology
1.00
1.00
0.00
1.00
0.00
0.00
0.00
0.00
0.00
0.00
0.88
Telecommunications
1.00
0.00
0.00
1.00
0.00
0.00
0.00
0.00
0.00
0.00
1.00
Utilities
0.84
0.58
0.00
0.00
0.16
0.26
0.00
0.05
0.84
0.42
1.00
0.50
By time:
2003
0.00
1.00
0.50
0.00
1.00
0.50
0.00
0.00
0.00
0.00
2004
0.33
0.67
0.33
0.33
0.67
0.67
0.00
0.33
0.33
0.00
0.67
2005
0.50
0.67
0.33
0.33
0.67
0.33
0.00
0.33
0.33
0.00
0.50
2006
0.80
0.55
0.40
0.40
0.20
0.15
0.00
0.10
0.30
0.25
0.75
2007
0.77
0.50
0.35
0.38
0.19
0.19
0.00
0.12
0.38
0.31
0.73
2008
0.81
0.59
0.30
0.41
0.26
0.15
0.00
0.11
0.33
0.30
0.78
2009
0.83
0.55
0.34
0.45
0.28
0.14
0.00
0.10
0.34
0.31
0.79
2010
0.83
0.55
0.31
0.59
0.28
0.17
0.00
0.10
0.34
0.31
0.86
2011
0.86
0.61
0.43
0.57
0.29
0.14
0.00
0.11
0.43
0.32
0.89
2012
0.76
0.56
0.40
0.60
0.32
0.16
0.00
0.12
0.52
0.32
0.92
2013
0.79
0.59
0.48
0.55
0.31
0.17
0.00
0.17
0.41
0.28
0.90
Notes:
Findings for KPIs are conditional on firms electing to provide information in their annual report and accounts (disclosure of KPIs is voluntary in the UK). KPI information is identified by
searching firms’ annual report and accounts using the following keyword list: “KPI”, “key performance indicator”, and “critical success factor”.
market-based KPIs, over 80 percent of firms align
executive compensation directly to market-based
metrics (see Table 3). Finally, while evidence from
Table 3 reveals that the incidence of non-financial
performance metrics significantly lags the incidence
accounting- and market-based performance in
executive compensation plans, findings in Table
14 demonstrate that firms identify non-financial
KPIs almost as frequently as accounting measures
(82 percent versus 100 percent, respectively) and
considerably more frequently that market measures
(82 percent versus 29 percent, respectively). Indeed,
CEO compensation contracts fail to link pay with
non-financial performance in 33 percent of the 183
firm-years where at least one non-financial KPI is
disclosed in the annual report and accounts.
Table 15 provides further evidence on the extent of
the disconnect between KPIs and the performance
metrics that determine CEO compensation. Of the
224 firm-years where KPI information is disclosed,
75 cases (33.5 percent) are associated with apparent
misalignment between the non-financial drivers of
business value and the performance metrics used to
incentivise and reward CEOs. In particular, one third of
the 183 firm-years where non-financial performance
metrics are listed among the suite of KPIs fail to
align CEO compensation with the corresponding
measure(s). Why a significant fraction of firms fail to
align CEO compensation with metrics that have been
explicitly identified by the board as critical measures of
organisational success is unclear and puzzling.
Evidence that compensation contracts fail to link
CEO pay directly with disclosed (non-financial) KPIs
while that the same time providing strong incentives
to increase dimensions of performance such as TSR
whose link with corporate strategy is less apparent
supports the moderate correlations between CEO pay
and value creation documented in Table 10. Having
identified key drivers of value, why many firms then
elect not to align CEO compensation incentives and
rewards directly with these factors remains something
of a mystery to us.
www.cfauk.org | 53
TABLE 15
CEO pay linked explicitly
to non-financial
performance metric
Non-financial KPI
Yes
No
Total
Yes
122
(54.46)
14
(6.25)
136
(60.71)
No
61
(27.23)
27
(12.05)
88
(39.29)
Total
183
(81.70)
41
(18.30)
224
(100.00)
Notes:
Findings for KPIs are conditional on firms electing to provide information in their annual report and accounts (disclosure of KPIs is voluntary in the UK). KPI information is identified
by searching firms’ annual report and accounts using the fol-lowing keyword list: “KPI”, “key performance indicator”, and “critical success factor”. Figures in parentheses refer to cell
frequencies as a fraction of the total sampling disclosing KPI information (N = 224).
19 SUMMARY AND CONCLUSIONS
To shed further light on executive compensation
plan design and the link between CEO pay and value
creation, we analyse compensation and performance
data for the period 2003-2013 using a sample of
30 companies from the FTSE-100 index. Empirical
tests focus on compensation arrangements for
CEOs because (i) they have primary responsibility for
strategic direction and organisational performance,
(ii) CEO pay structures are a good proxy for
executive-level compensation arrangements more
generally, and (iii) CEO pay attracts most attention from
investors, governance activists, and the media.
The analysis seeks evidence on three questions. First,
what is the degree of alignment between alternative
measures of periodic performance? Second, to
what extent is executive compensation aligned with
alternative measures of periodic performance and
in particular with proxies for value creation? Third,
how does the set of performance metrics employed
in executive compensation plans align with the key
performance indicators that drive value at the individual
company level? Key findings relating to these questions
are summarised as follows:
»» Consistent with extant academic research and
survey evidence, we find that EPS and TSR are the
most commonly employed performance metrics in
CEO compensation contracts throughout our sample
period. In contrast, value-based metrics such as FCF
and RI are rarely used. (As an aside, our analysis also
highlights the conceptual and practical problems
associated with operationalising FCF, which may
partly explain why this metric has failed to gain
widespread traction as a basis for measuring period
performance);
54 | www.cfauk.org
»» Performance metrics that are commonly used in CEO
compensation contracts (e.g., EPS, TSR, ROA and
ROE) display relatively low correlation (< 0.5) with
theoretically superior measures of periodic value
creation such as FCF and RI;
»» CEO pay measured from a range of perspectives also
displays low correlation (< 0.3) with firm performance
regardless of the specific performance metric
employed. These results support prior evidence
that CEO compensation outcomes are only loosely
associated with firm value;
»» In relative terms, the correlation between CEO
compensation and value creation metrics such as RI
and FCF (computed using an all-inclusive approach)
is at least as strong as for contracted performance
metrics such as EPS and TSR. (Note, however, that
conclusions for FCF are sensitive to the specific
definition employed: when FCF is measured using
a capital maintenance approach we observe little
correlation between CEO pay and value creation);
»» Lack of close alignment between contracted
performance metrics and measures of fundamental
value creation raise concern about prevailing
executive incentive structures among large UK-listed
firms;
disclose to shareholders and the corresponding
metrics used to incentivise and reward senior
executives. In particular, approximately a third
of our sample displays apparent misalignment
between the non-financial drivers of business value
and the performance metrics used to incentivise and
reward CEOs.
On the one hand these results provide a degree of
reassurance to the extent they confirm the existence of
a statistically and economically significant link between
CEO pay and two measures of periodic value creation
(RI and FCF defined using an all-inclusive approach).
The correlations for RI and FCF are at least as large as
those documented for TSR and EPS using pooled tests;
and in some cases the association is significantly
stronger. Results suggest current CEO pay structures
incentivise and reward important aspects of value
creation even though the specific performance metrics
used in executive contracts are not directly linked with
value creation in many cases.
On the other hand our findings raise cause for concern
given that (i) a large fraction of CEO pay appears
unrelated to periodic value creation and (ii) key
aspects of compensation consistently correlate with
performance metrics such as TSR and EPS growth
whose theoretical link with value creation is fragile.
Collectively, results highlight a worrying disconnect
between CEO compensation and measures of
fundamental value creation to all capital providers,
and therefore raise important questions about the
structure and effectiveness of prevailing compensation
arrangements for UK executives.
Several caveats are appropriate when interpreting
results and conclusions described above. First,
empirical analyses are conducted using a sample
of FTSE-100 firms and as such care is required when
seeking to generalise findings to the boarder population
of UK-listed equities. Since our analysis focuses on the
largest publicly traded firms that typically comply with
best-practice governance and remuneration guidelines,
we suspect that our findings reflect an upper bound
on the strength of the link between executive pay and
fundamental value creation. On the other hand, it is
possible that agency problems are more acute for such
entities and that as a result the disconnect between
CEO pay and value creation may be less apparent
for smaller firms. Second, our analyses focus on raw
performance measures whereas firm performance
is often benchmarked against a share index or peer
group for the purposes of determining executive pay. It
is possible that relative performance evaluation yields
closer alignment with value creation and that as a
result our findings understate the degree of association
between pay and value for all capital providers. Finally,
the analysis is subject to the usual caveats regarding
interpretation of statistical findings generally, and
in particular where statistical methods are applied
to relatively sparse data. We seek to address these
limitations by conducting a series of sensitivity tests
designed to assess the robustness of our findings and
conclusions. Results from these supplementary tests
are entirely consistent with those reported in the main
body of the report. Nevertheless, caution is still required
when interpreting statistical associations based on
small sample sizes.
»» We find some (albeit statistically weak) evidence
that high reliance on EPS performance conditions
may lead management to pursue actions aimed at
increasing short-term EPS rather than enhancing
long-term value creation. Our results are best
interpreted as suggestive given the small sample
size. Nevertheless, they are consistent with
large-sample academic research documenting
similar effects.
»» There exists a material disconnect between the key
performance indicators (KPIs) that management
www.cfauk.org | 55
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