Note · Opinion, not rated
Management gets paid for the wrong thing.
Almost every complaint investors make about corporate behavior is a complaint about a compensation plan they never read. The proxy statement explains more of what a company does than the strategy deck ever will, and it is filed every year by every public company in America.
The metric is the strategy
If you want to know what a management team will do, do not read what they say they will do. Find out what they are paid to do. Compensation committees pick a handful of measures, attach large sums of money to them, and then act surprised when those measures go up.
The problem is that the most common measures can all be moved without the business getting any better. Here are three, with the arithmetic.
One: an EPS target, met by shrinking the denominator
Worked example
Net income flat at $500M, 100M shares, $40 a share, and a buyback retiring 6% of the count
- Earnings per share before
- $5.00
- Earnings per share after
- $5.32
- Reported EPS growth
- 6.4%
- Improvement in the business
- none
$240M of cash converted into 6.4% of "growth". If the bonus triggers on mid-single-digit EPS growth, it is now paid.
This is not an argument against buybacks. A buyback below intrinsic value creates real value for the holders who stay, which is the entire subject of another note. It is an argument that an EPS target cannot tell the difference between a good buyback, a bad buyback, and an operational improvement. It pays identically for all three.
Two: a revenue or growth target, met by burning capital
Tie pay to revenue, or to "growth", and you have asked management to expand regardless of what the expansion earns.
Worked example
$100M of after-tax operating profit growing 10%, earning 6% on the new capital, against a 9% cost of capital
- Reinvestment required
- 167% of profit
- Free cash flow
- −$73.33M
- Value if it stands still
- $1,111M
- Value if it hits the target
- −$232M
Reinvestment above 100% means the company must raise outside money to fund its own expansion. The growth target is met, the bonus is paid, and roughly $1,343M of value has been converted into a larger business nobody should have wanted more of.
The fix is not complicated and is rare anyway: measure returns on capital rather than the size of it. Growth funded below the cost of capital destroys value, and a pay plan that cannot see the difference will reliably buy the wrong kind.
Three: paying people in a currency the income statement understates
Stock-based compensation is a real cost that does not leave the bank account, which is why so much reporting quietly treats it as though it were free.
Issue 3% of your shares to employees every year for 10 years and existing holders own 26.3% less of the company at the end of it. No single year looks dramatic. That is the mechanism.
The compounding problem is that stock compensation is usually excluded from the adjusted earnings figures that the pay plan measures. So the cost of paying management is removed from the number that determines how much management is paid. Stated that plainly it sounds like a joke, and it is close to standard practice.
What to actually read
The proxy statement, form DEF 14A, filed annually. Skip the pay tables, which are about amounts and tell you very little. Go to the Compensation Discussion and Analysis, and find the performance measures and their weightings. That section is the company's real strategy, stated in the only language that binds.
Good signs. Return on invested capital or return on tangible equity as a measure. Multi-year performance periods rather than annual. Relative measures against peers, which strip out luck from a sector-wide move. Meaningful share ownership requirements with long holding periods after vesting.
Warning signs. Adjusted EPS as the dominant measure. Revenue or "total shareholder return" over a single year. Targets that get reset downward after a miss. Metrics that exclude the cost of the compensation being decided. Any measure management can move with the balance sheet in a quarter.
The honest caveat
Incentives are not destiny. Plenty of managers behave well under bad plans, and a good plan will not rescue a poor operator. Compensation committees also face a real constraint: measures have to be objective and verifiable, which pushes them toward exactly the simple accounting figures that are easiest to game. Return on capital is the better measure and it is also harder to define, easier to dispute, and slower to show results.
So this is not a claim that badly designed pay explains everything. It is a claim that it explains more than almost any other single document you can read about a company, and that it takes about twenty minutes.
When a company does something that looks irrational, the usual explanation is not that management is stupid. It is that somebody is being paid for exactly this.