While CEO’s compensation packages are typically tied to performance, researchers found that the choice of CEO performance measures differ considerably across the S&P 500 companies. Larger more complex companies tend to have market-based measures, while smaller or less complex firms slant more towards accounting-based measures.
This latest study – “Performance Terms in CEO Compensation Contracts” – co-authored by David De Angelis, an assistant professor of finance at Rice University’s Jones Graduate School of Business, and Yaniv Grinstein, an associate professor of finance at Cornell University’s Johnson Graduate School of Management, will be published in the next issue of the journal Review of Finance.
Market-based versus accounting-based measures
De Angelis, an assistant professor of finance at Rice University’s Jones Graduate School of Business, said:
“On average, firms rely mostly on accounting-based performance measures, among which they put heavier weights on income measures, sales and accounting returns.”
“Our findings are in line with predictions from optimal contracting theories: Firms with complex activities and large growth opportunities tend to tie a larger fraction of the awards to market-based measures rather than to accounting-based measures.”
De Angelis and Grinstein focused on companies’ filings of their annual proxy statements with the U.S. Securities and Exchange Commission (SEC), which as from December 2006 had to disclose more comprehensively how they tie CEO compensation to performance.
They gathered and analyzed data from S&P 500 companies on the terms of performance-based awards in CEO compensation contracts.
The S&P 500, also known as the Standard & Poor’s 500, includes the largest 500 companies having common stock listed on the New York Stock Exchange (NYSE) or NASDAQ.
Their sample included 494 S&P 500 firms as of December 2007. Specifically, the authors looked at each company’s proxy statement section related to CEO compensation for 2007.
CEO performance measures pre-specified by firms
Grinstein and De Angelis found, in general, that firms pre-specified the performance goals of their CEO over a range of performance measures.
On average, the estimated value of performance-based awards were measured as follows:
- 79% is based on accounting-performance measures
- 13% is based on stock-performance measures
- 8% is based on non-financial measures.
Larger companies as well as firms with greater growth opportunities tend to slant more towards market-based measures, while more mature businesses rely more heavily on accounting-based measures, the authors found.
Firms with growth opportunities adopt sales measures
Companies with larger growth opportunities use sales more, while accounting returns are used more heavily by more mature companies with fewer opportunities for growth.
Similar performance measures were more commonly found among companies in similar sectors, the authors wrote.
The authors wrote:
“In growth firms, where CEO optimal actions are improving long-term growth opportunities, end-of-year accounting performance measures are likely to be less informative of optimal CEO actions. For these firms, stock price performance, which captures investors’ perception regarding firms’ long-term growth opportunities, is a more informative measure.”
Among accounting measures, growth firms were found to rely more on sales-growth measures, which again seize on CEO actions linked to growth. Mature firms, on the other hand, where the CEO focuses more on maximizing value from existing operations, end-of-year accounting performance measures describe CEO actions in more detail.
The researchers added that two interesting findings from their study need to be examined further:
“First, a large portion of CEO awards is given at the discretion of the board. How exactly this portion of the awards is determined is an interesting topic for future research.”
“Second, we find that CEO shareholdings have little association with the level of market-based awards in the CEO contract. This result is puzzling because we expect CEO shareholdings to act as a substitute to the market-based awards. We believe that further investigation of this result is another fruitful area for future research.”
CEO shareholding a key consideration in compensation packages
CEO stockholding appears to be a major consideration in compensation decisions, given the recent trend of $1 salaries among high-profile bosses such as Hewlett-Packard’s Meg Whitman, Facebook’s Mark Zuckerberg and Apple’s Steve Jobs
Limiting the salary to $1 could be a way of showing that the CEO believes in the company, de Angelis said, and consequently, is an opportunity to enhance the firm’s share price.
De Angelis said:
“These CEOs are likely to own a large stake in the firm, so the incentives coming from the compensation are rather small compared with the incentives associated with their holdings. This $1 salary tack could send a positive signal to the market, meaning the stock price might increase and potentially earn the CEO even more through their holdings.”