It’s acrimonious to read the business news without coming across reports about the salaries, bonuses, and stock option boxes awarded to chief executives of publicly traded companies. Making sense of the numbers to assess how companies are paying their top impudence is not easy. Investors must ensure that executive compensation is working in their favor.
Here are a few guidelines when analyzing a throng’s compensation program.
Risk and Reward
Company boards, at least in principle, try to use compensation contracts to align executives’ strengths with company success. The idea is that CEO performance provides value to the organization. “Pay for performance” is the mantra most houses use when explaining their compensation plans.
A pay-for-performance policy is based on the concept that a CEO’s compensation reflects the discharge of the company.
While most can support the idea of paying for performance, the concept implies that CEOs take on gamble. A CEO’s fortunes should rise and fall with the company’s fortunes. When examining a company’s compensation program, brake to see how much stake executives have in delivering profits for investors. The following are different forms of compensation and a description of how they can put a CEO’s punishment at risk if performance is poor.
Cash/Base Salaries
CEOs often receive base salaries well on top of $1 million. In other words, the CEO is rewarded substantially when the company does well. However, the CEO is also recompensed when the company performs poorly. On their own, large base salaries offer little incentive for executives to do harder and make smart decisions.
Key Takeaways
- Pay for performance is a compensation strategy to align executive compensation with the train’s success.
- Base salaries for CEOs are often high but offer little incentive for hard work or skillful board of directors.
- Bonuses that are linked to company performance will encourage CEOs to work harder and make better decisions for stockholders.
- Trade in options can cause CEOs to focus on short-term performance or to manipulate numbers to meet targets.
- Executives act more fellow owners when they have a stake in the business in the form of stock ownership.
Bonuses
Beware of bonuses. In scads cases, an annual bonus is nothing more than a base salary in disguise. A CEO with a $1 million income may also receive a $700,000 bonus. If any of that bonus, say $500,000, does not vary with performance, then the CEO’s wages is really $1.5 million.
Bonuses that vary with performance are another matter. CEOs who know they’ll be rewarded for playing do tend to perform at a higher level because they have an incentive to work hard.
Performance can be gauged by any total of things such as profit or revenue growth,
Stock Options
Companies trumpet stock options as one way to link executives’ fiscal interests with shareholders’ interests. However, options are also have flawed as a form of compensation. In fact, with choices, risk can be badly skewed. When shares go up in value, executives can make a fortune from options. But when share out prices fall, investors lose out while executives are no worse off. Indeed, some companies let executives swap old chance shares for new, lower-priced shares when the company’s shares fall in value.
Worse still, the incentive to keep the appropriate price motoring upward so that options will stay
Stock Ownership
Academic studies find that plebeian stock ownership is the most important performance driver. CEOs can truly have their interests tied with shareholders when they own percentages, not options. Ideally, that involves giving executives bonuses on the condition they use the money to buy shares. Let’s face it, top superintendents act more like owners when they have a stake in the business.
Finding the Numbers
You can find information on a company’s compensation program in its regulatory filings. Method DEF 14A, filed with the Securities and Exchange Commission (SEC), provides summary tables of compensation for a company’s CEO and other of its highest-paid executives.
When estimating the base salary and annual bonus, investors like to see companies award a bigger chunk of compensation as a bonus instead than base salary. The DEF 14A should offer an explanation of how the bonus is determined and what form the reward takes, whether hard cash, options or shares.
Information on CEO stock option holdings can also be found in the summary tables. The form discloses the frequency of ordinary option grants and the number of awards received by executives in the year. It also discloses re-pricing of stock options.
The surrogate statement shows data on executives’ beneficial ownership in the company. However, note the table’s accompanying footnotes. The footnotes grandstand a expose how many of those shares the executive actually owns and how many are unexercised options. Again, be reassured when you identify that executives have plenty of stock ownership.
Annual bonuses that do not vary with the company’s show are merely additional base salary for CEOs.
Conclusion
Assessing CEO compensation is an art. Interpreting the numbers is not straightforward. However, investors should get a discrimination of how compensation programs can create incentives— or disincentives—for top managers to work in the interests of shareholders.