#35 Management & incentive schemes II: the bad
Why EPS, FCF/share, or TSR are not good value creation metrics for shareholders
We have become aware of a widespread misconception that incentive systems based on EPS or FCF/share are aligned with shareholder interests. It is a rather dangerous situation to believe that these parameters are directly and by themselves synonymous with value creation. In this post, we analyze why.
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The Remuneration Committee within the Board of Directors of a company normally hires consultants to bring in industry best practices. The truth is that we do not really understand how supposed experts in matching executive compensation with shareholder interests come up with such monstrosities. Let's keep in mind that today we are ignoring schemes where net metrics are incentivized: be it net revenue, Adj. EBITDA, net income, or even free cash flow. All those incentivize growth by growth and all those might be very harmful long term.
When looking at an incentive system, our minds should go straight to second-order thoughts. Remuneration linked to an increase in earnings per share (EPS) or free cash flow per share (FCF/share) sounds fantastic. What shareholder wouldn't want their FCF to increase?
Our answer would be: watch out! You can increase FCF/share by destroying value. Increasing FCF/share is not necessarily and always a good thing. And that is what today's first point is about. Let's try to explain it with an example:
Imagine you are the newly appointed CEO of the company Pears. The company has a market cap of 200m and last year the profit was 10m. A few years ago Pears developed a tremendously successful product that generated very high margins and returns for the company. However, it seems that the penetration boundaries might have been reached and expected future growth is very limited. The Board of Directors hires you to find new growth segments. Your compensation and incentive scheme is as follows:
Base salary: 200k per year
Short-term incentives: Yearly bonus up to 200% of base salary based on revenue growth, EPS growth, and FCF/share growth, each of them evenly weighted and upon achievement of a particular threshold.
Long-term incentives: 600% of base salary in stock options released after 3 years and depending on TSR compared to an Index.
To be fair, we have to say that this remuneration scheme is already better than 95% of the existing ones in publicly traded companies. Even so, it is far from perfect because it can lead to actions that destroy shareholder value.
EPS or FCF/share
We have our first meeting with our management colleagues. Pears' flagship product is expected to grow 5% this year. But it's not enough. You've been hired to grow, so you get down to work. Eventually, you come up with two options to address the lack of short-term growth:
Design, develop, manufacture, distribute and market a brand-new product.
Acquire a company that already has one ready to market.
We need short-term results, so you decide to acquire the company. Pears has some cash on the balance sheet. Additionally, you decide to leverage the balance sheet with debt to improve returns a bit. This will have an immediate impact on your income statement and will also meet your 3 short-term incentives. You will increase revenue, EPS, and FCF/share (this last one is not that clear, but well, 2/3 in the worst case).
Furthermore, and to boost future growth, you order to launch the development of a new product. But you don't want to harm short-term too much your potential EPS and FCF/share, so you under-invest in your R&D and marketing expenses.
Finally, to achieve your goals of EPS and FCF/share, you decide to invest some of the remaining cash reserves in buying back stock. That way you will boost your key metrics and "create value".
You could be proud of yourself. You have brought a new wave of growth to Pears. You have a new product pipeline and all the metrics for what you were contracted are improving.
However, one question comes to our mind. Have you created any shareholder value? We simply don't know. The only thing we know is that you have assumed more financial risk. And that's just the plain reality. Neither revenue growth, nor EPS growth, nor FCF/share measure whether you have created value or not.
Total shareholder return (TSR)
One might think that if these decisions are not generating value, the CEO would be penalized in the long run because he would not receive his long-term incentive. And that might be true, but again, the devil is in the details.
First of all, in general, few people think about the repercussions of their decisions 3 or more years down the road. We usually focus on putting out the current fires we have right under our noses. Human beings, as a rule, no matter what executives say, do not think in the long term.
Most of the long-term incentives that are determined by TSR schemes are benchmarked to an Index, not by setting minimum net returns. Imagine the long-term incentive linked to a TSR of 15% annualized. It would be nice, but this is almost never the case. It is referenced to a benchmark which most of the time is not a fair comparison. Is it fair that Apple compares its performance against the S&P 500, when 15% of the index are financial companies, 13% are health care, 10% are industrials, or 6% are energy companies?
Finally, what bothers us the most. In most cases, and despite the fact that the comparison is already distorted, we have a final surprise. Executives will receive 100% of the incentive if the TSR is the same as the benchmark! You don't have to outperform, you just have to be as "bad" as the rest. And what is even worse, in most cases, executives will receive part of their incentives even if the TSR is much lower than the benchmark.
Thus we see that what seemed a priori to be a good incentive system, or at least above average, does not, at any time, measure the real creation of value for shareholders.
One might think the great companies of our time should have the best incentive systems for their executives. Nothing could be further from the truth. Let's take a look at the remunerations of 3 of the big ones to observe what at first glance may appear to be very similar, it is in reality quite different.
Simplifying things a bit, Apple's management compensation is composed of a fixed base salary, a cash compensation/bonus based on sales and operating income each year, and an equity compensation dependent on performance against the S&P 500.
Short-term incentives are based on a sales and operating income target.
While the equity awards are based on their relative comparison to the S&P 500.
In a relatively similar manner to Apple, Adobe grants a base salary, a target cash incentive based on a mix of corporate performance (sales and EPS) and individual results, and a performance share award depending on performance against the Nasdaq.
Amazon, on the other hand, approaches it differently. The salary paid to its executives is ridiculous. However, the company grants its top executives large stock packages vested over a long period of time.
And they provide reasoning for it:
Mr. Jassy received a restricted stock unit award for 61,000 shares, which vests over 10 years from grant, from 2023 through 2031, with more than 80% of the shares scheduled to vest between 5 and 10 years after grant. Faced with the first CEO succession in the Company’s history, the Leadership Development and Compensation Committee determined it important to provide for clarity and stability through an award that is designed to establish a long-term owner’s perspective and encourage bold, long-term initiatives, in the same manner that Mr. Bezos’s shares as founder incentivized him to focus on long-term, expansive growth. Accordingly, this award is intended to represent most of Mr. Jassy’s compensation for the coming years.
The Committee intends for this restricted stock unit award to serve as a long-term incentive for Mr. Jassy, and, accordingly, believes it should be viewed as compensation over the 10-year term and not solely as compensation for 2021.
None of these incentive systems is perfect. They are far from good. None ensures that executives are remunerated according to the value they create for shareholders. However, Amazon has a compensation scheme that incentivizes its executives to create value over the long term if they want to make extra profit from them. And we say extra because if Andy Jassy does not create any value in the next 10 years of tenure, he will still receive his compensation in full. But at least he would suffer also the downside.
In the next post, the last in this series on compensation and incentives, we will look at schemes that are truly aligned with a correct capital allocation and value creation for shareholders, and therefore, for society.
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great coverage, thank you, super interesting!