The Big Problem With CEO Compensation

In the video below, The Motley Fool speaks with Roger Martin, strategy expert and dean of the Rotman School of Management at the University of Toronto. We discuss executive compensation, specifically what he thinks of the current way executives are compensated. Martin believes that stock-based compensation for executives leads many of them to focus too much on the short term and can lead to management making decisions based on compensation schedules rather than the good of the business. 

A transcript follows the video.

The full interview with Roger Martin can be seen here, in which we discuss a number of topics including Bill Ackman, innovation, corporate responsibility, executive compensation, and how to pick out great companies. Martin is the coauthor of "Playing to Win," a new book on strategy written with former Procter & Gamble CEO A.G. Lafley.

Brendan Byrnes: Executive compensation. You've said in the past that right now the executive compensation system is deeply flawed. What is wrong with it right now, and how has it evolved over time?

Roger Martin: What's wrong with it now is it's so much based on stock-based compensation, and that has evolved since about 1980. Prior to 1980, there was actually almost no consequential amount of stock-based compensation in the American economy.

In 1976, less than 1% of CEO compensation was stock-based. By 2000, it had become 50%.

The deep flaw, I think, is if you really think about what a stock price is, a stock price is simply everybody in the market's view of how well the company is going to do in the future. It's not a real thing. It's just about expectations of the future.

Brendan: Another Warren Buffett. In the short term, it's a popularity contest.

Martin: That's absolutely right. So, in essence, when you give somebody stock-based compensation ... If you're the CEO of a company, I'm on the board and I give you a stock option at the current market price, and say, "This is your incentive compensation, Brendan. You should make the most of this." What they're actually saying to you is not, "Make the company perform better." They're saying, "Raise expectations about future performance by those people out there called investors."

I would argue there are a lot easier ways to do that, especially in the short term, than actually work really hard to build better products and be more efficient and effective and a better company.

Brendan: Let's talk about those ways. How do you do it better? Do you look at a model like maybe Jeff Bezos at Amazon and say, "He's focused on the long term, that's what we need more of?"

Martin: Yes, I think so. I really think companies have to -- and Paul Polman at Unilever when he took over in January 2009, the Google guys who said when they went public, "We will never give quarterly guidance -- I think you have to establish that early on, that you're interested in growing the company for the long run.

You can't have it both ways. I'm not as sympathetic to the CEOs who complain about the capital markets as some people are. The minute you wander down to Wall Street and say, "We just had a great blow-out quarter. You should really all be excited and push our stock price up," you're now in bed with those same people.

Brendan: You can't have it both ways.

Martin: You do not have it both ways. I think the ones who just are really clear -- Jeff Bezos, Paul Polman, the Google guys -- and then stick with that for the long run are absolutely doing the best thing for their company because it enables them to actually invest in creating real performance.

As Warren Buffett would say, in due course the stock market does reflect underlying values. But, boy, in the meantime, there can be massive fluctuation.