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Compensation

It's easy to grouse about executive pay and complain that top managers, like movie stars, are something called "overpaid." They're certainly well-paid: A recent article by Bloomberg columnist Graef Crystal said that American executive pay has risen 40 times over the last 33 years -- compared with five times for American workers.

But how much should they be paid? There isn't a set formula, though Crystal -- a former compensation consultant turned critic -- argues that compensation should increase in line with corporate stock performance.

While there may not be a simple calculation investors can use to determine what, for example, their CEO should make, it may be useful to examine how her compensation stacks up to her counterparts' at competing companies, as well as how it has changed relative to stock performance. If either of these numbers is consistently out of whack, your company may be stewarded by a board of directors that doesn't take its job very seriously.

Lately there has been a growing controversy over equity compensation -- specifically, stock options -- which make up most of an executive pay package. (Other components include bonus, long-term payouts, and "fringe" benefits such as club memberships, auto allowances, and so on.) Generally, it's considered good practice to include stock options in compensation since it ostensibly ties individual reward to company performance. It is certainly common, and almost required to attract workers in technology fields. Warren Buffett's Berkshire Hathaway(NYSE: BRK.A), on the other hand, does not issue stock to its managers -- instead preferring to write them good, old-fashioned paychecks with the amount tied closely to performance.

Why Buffett does this -- beyond the simple fact that, hey, everyone likes cash -- becomes clear not only from reading his letters to Berkshire stockholders but from the attention the media has given this matter lately. (It rated the cover story of the June 25 Fortune.) In short, the controversy swirls around the tax treatment of options: Companies can defer taxation on compensation based upon options, which means that while compensation comprised of cash or stock is taxed at market value, options are assumed to have zero value at issuance.

As a result, the employee pays no tax and the company records no expense until the options are exercised. This, critics say, deflates corporate compensation expense in the near-term, and severely distorts earnings.

There are a number of ways investors can approach this matter. One, discussed by Bill Mann in "The Danger of Stock Options," is a strategy used by Buffett to determine the present value of a company's option grants. The number that exercise produces can be subtracted from reported net income to get a truer gauge of a company's economic performance. The two figures can be wildly different: In that case, wrote Mann, "I would never... invest money into a company that treats its outside shareholders in such a cavalier fashion."

Investors may also want to keep an eye on two other figures: The proportion of issued shares a company gives to its executives each year, and the degree of a company's pro forma dilution. The first can be checked by heading into the "Notes to Consolidated Financial Statements" section of a company's annual report. Look for the table that discusses stock option activity in employee benefit plans. If the number of options granted in a given year comes to more than 5% of the total number of shares that company issued during that same year, it may be a sign that the company is playing fast and loose with options to boost earnings.

Pro forma dilution, meanwhile, can usually be found in a section that discusses what would have happened "had compensation cost for the company's stock-based compensation plans been determined based on the fair value at the grant dates for awards under those plans." (That example comes from the Gap Inc. (NYSE: GPS) annual report.) If the company's pro forma diluted earnings per share number comes to less than 90% of its as-reported figure, it's another warning sign.

Both the 5% and 90% figures are just rough guidelines, not firm rules. And some money managers will relax on one number if the other looks favorable. Either way, when these flags wave investors may want to pry a bit more in an attempt to see if there are specific reasons for outlying compensation numbers: A company may have recruited a hotshot CEO, rewarded a leader for exceptional performance, or boosted compensation to match its competitors. Whatever the reasons, an investor will need to weigh them individually and decide whether a company is getting its money's worth.

When all is said and done, however, there may be little an individual investor can do when unhappy with the compensation policies of a company short of selling the stock. Perhaps the next-best thing is fervent letter writing: According to one study, shareholder proposals (which are sometimes voted on at annual meetings) have shown little ability to drive reform, while pressure from the news media and institutional investors has been more effective.

Next: Conclusion »

Dave Marino-Nachison's (TMF Braden) stock holdings can be viewed online. The Motley Fool has a full disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 16, 2014, at 9:02 PM, elijed23 wrote:

    Watching out for issued shares is something investors should do. Something in particular is how many shares are issued to the executives. Look on a yearly scale, it will help.

    Elisa Jed | http://www.lshlaw.com

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