Performance Metrics and Their Link to Value

Posted by Michael McCauley, Florida State Board of Administration, on Wednesday February 20, 2013 at 9:18 am
  • Print
  • email
  • Twitter
Editor’s Note: Michael McCauley is Senior Officer, Investment Programs & Governance, of the Florida State Board of Administration (the “SBA”). This post is based on a Farient Advisors study, titled “Performance Metrics and Their Link to Value,” which was sponsored by the Florida SBA. The full study is available here.

The State Board of Administration (SBA) sponsored an executive compensation research study by Farient Advisors LLC, covering 1,800 companies, 24 Industry groups, and fourteen years of data (from 1998-2011). The research project identifies the primary metrics used in executive compensation plans, overall and by industry, company size, and valuation premiums, and then tests these metrics to determine whether the metrics being used have the highest impact on total stock returns.

The study provides the most definitive answer to date on a critical question—are companies choosing their long-term incentive metrics wisely for the most sustainable benefit to shareowners?

The SBA evaluates hundreds of executive compensation plans. The SBA critically examines corporate compensation structures for quality and efficacy of their design. As part of this effort, we have frequently addressed a critical question that has challenged most shareowners – how effective are the individual performance objectives embedded within virtually all compensation structures, and how closely are they tied to the company’s stock price? Many compensation committees struggle with this central thesis when developing long-term incentive plans for the companies they serve as directors. The performance metrics selected, as determined by the company and its board of directors, are deemed by many observers to be the best measures of corporate success. Investors and other interested stakeholders wish to validate that these metrics are in fact linked to Total Shareowner Return (TSR).

The SBA has adopted policies to evaluate the design features and individual components utilized within LTIPs, in order to understand what incentives are created and how performance against those measures impacts shareowner value.

Company Universe & Methodology

To conduct this research, Farient identified the primary metrics being used in executive compensation plans, overall and by industry, company size, and valuation premiums. Farient then tested the extent to which those metrics correspond to TSR to help answer the question, – are companies choosing the right performance metrics?

Data from 1998-2011 were used in the research, capturing the top 750 companies in market capitalization for each year covered, for what comprised a database of over 1,800 companies. Data on performance metrics were supplemented by additional data provided by Farient on executive pay trends. Farient conducted an in-depth analysis based on its experience analyzing and developing pay programs and performance measurement systems that link to shareowner value.

In conducting this research, Farient analyzed companies by industry (as indicated by their 2- and 4-digit global industrial classification standard codes (GICS)), size (as indicated by market capitalization), and valuation premiums (i.e., the premium of the market value over the book value of the company). All data collected pertain to that for the named executive officers (or NEO’s), as disclosed in company proxy reports to shareowners.

Study Findings

This study found that among companies using performance-based long-term incentives; most (53 percent) use a mix of TSR and financial measures in their long-term equity plans; others (28 percent) use financial measures only; and a smaller minority (15 percent) use TSR only. This allocation of performance measure usage underscores the need to identify the right metrics for a given firm.

The study found that, in aggregate, performance metrics are generally well-aligned with shareowner value. Earnings growth, followed by returns and revenue growth, has the greatest impact on stock prices. This result matches the usage patterns for financial metrics in long-term incentives: earnings growth is the most popular financial measure, followed by returns and revenue growth. TSR (usually measured on a relative basis) is used as a direct measure of shareowner value in over 40 percent of companies with performance-based long-term incentives.

This review also found that many industries have a number of metrics to choose from; with half of the 24 industry groups studied having at least three metric categories with strong correlations to TSR. However, the optimal use of measures differs considerably by industry. Industry group classification, as an indicator of business model, has the strongest influence on the type of performance metrics in place over the study’s time frame, with size and valuation premiums having little impact on metric selection.

The study’s researchers found that approximately half of all industry groups could use some improvement in their selection of performance measures. The companies in these industries either are not using the metrics that are most strongly correlated to value or, when the overall correlations of financial metrics to shareowner value are poor, they are not sufficiently using TSR as a direct measure of shareowner performance.

Farient research found that earnings growth measures have the strongest correlation to value (total stock price return). Earnings growth was ranked #1 in 17 of the 24 industry groups (with one tie). It was not unusual to see all three earnings growth metrics that were tested – EPS, Net Income and Operating Income – near or at the top of the correlation results. Revenue Growth was often the second most highly correlated metric.

Based on the SBA’s research with Farient Advisors, there are several key takeaways for shareowners and boards of directors to consider when they design and evaluate long-term incentive compensation plans.

  • 1. Companies should undertake their own analysis to determine which measures of performance have the most influence on shareowner value. Various measurement definitions (for example, approaches to depreciation, capital expenditures, asset definitions, and other items) could make a significant difference to shareowner value and should be given careful consideration.
  • 2. Companies should identify two or three key metrics that appropriately balance growth and returns and demonstrate a proven link to value. If overall correlations to value are poor for existing long-term incentive plans, a board should change the metrics.
  • 3. Investors are likely to increase engagement activities around executive compensation in general, and specifically on performance metrics. In communicating with investors, companies should present compelling evidence as to how various measures of performance will lead to enhanced shareowner value.

The SBA governance brief can be viewed here.

 

 

Add your comment below:

(required)

(required but not published)

RSS feed for comments on this post. TrackBack URI

 
  •  » A "Web Winner" by The Philadelphia Inquirer
  •  » A "Top Blog" by LexisNexis
  •  » A "10 out of 10" by the American Association of Law Librarians Blog
  •  » A source for "insight into the latest developments" by Directorship Magazine