Since the GFC, there has been a renewed focus on executive remuneration for publically listed companies. In particular the size and structure of bonus schemes came to the fore after ludicrous payments were made to US banks executives, despite their companies being bailed out by taxpayer funds. Australia was not immune to this disease, with executive wage growth far out stripping average wage increases over the last decade. So hostile were public attitudes in Australia towards executive pay and bonuses that the “two-strike” rule was enacted, where:
- companies that receive 25 per cent or more ‘no’ votes for the remuneration policy in two consecutive years must put to shareholders a board spill resolution at the AGM,
- If this resolution proves successful, all board members (except the managing director) must stand for re-election for their positions
These new laws gave some teeth to the non-binding shareholder votes that were often ignored by boards in the past.
Since these new laws were passed, I’ve read many annual reports that highlight “shareholder concern” over executive pay (as if it were a new thing). These same reports invariably contain changes to remuneration policies that “better align shareholder and executive interest” as boards react to the new environment of accountability.
Despite this new-found respect for shareholder wishes, I still think the majority of remuneration policies for ASX companies are poorly structured – especially bonus pay. To my mind, management bonuses should be aligned squarely with shareholder interest. This invariably means alignment with the long-term performance of the company.
Below I describe the most commonly-used bonus pay metrics I have come across, as well as their inherent flaws:
Earnings per share: An oft-used and potentially misleading metric, earnings per share (EPS) growth records the increase in company earnings divided by the number of ordinary shares. Earnings is typically net profit, but in some cases it is earnings before interest and tax or other nebulous earnings measures. Thismetric can be easily boosted via increased borrowings, which are used to purchase more assets or buy other companies. The increase in assets should produce an increase in earnings; however the number of shares on the registry remains the same. As long as interest rates are lower than the resulting return on the debt employed, EPS will go up and management get a fat bonus cheque. The trouble is, balance sheet risk increases and as soon as earnings drop or interest rates go up the company can be in serious trouble. Take a look at listed real estate companies prior to the GFC for examples of EPS gone wrong.
Total Shareholder Returns (TSR): TSR measures the dividends paid and the share price change over a given period (usually 3-5 years). While it sounds better than EPS, it can still be manipulated by generous dividend policies which artificially boost share price in the short term. It also uses the share price as a primary metric, when in fact it’s a secondary outcome of a well-run company. Get the company fundamentals right, and the share price and dividends increase – not the other way around.
Relative Return on Equity: I am a big fan of the return on equity (ROE) measure because it measures how efficiently shareholder capital is being used to generate profit. You know, the whole successful business thing. However, almost every ROE measure I have read is a relative measure – that is, measured against companies in the same industry or index. Relative measures really get my goat because a 20% loss can be rewarded if your peers lose 25%. Unfortunately for the shareholder a 20% loss is still a big loss in the company he or she part owns – who on earth should be rewarded for that?
So what should be the metrics for bonus pay Mr Q?? Well, if I were Emperor for a day and was given the power to determine bonus metrics, I’d choose the following:
Absolute Return on Equity: High ROE tells us the managers are generating good profits on our precious shareholder capital. It is the primary metric in business and should be the major metric against which all mature businesses are measured. It’s not terribly got for start-ups (especially miners) as earnings are often negative until production comes on line, but for a mature business like Bluescope, Woolworths or Wesfarmers, it should be a central part of any bonus metric. Note also the use of the word absolute – it must always be positive.
The only downside to ROE is that it can be boosted by the use of debt, much like EPS. Which leads us to the second metric.
Absolute Return on Funds Employed: Return on funds employed measures after-tax profit divided by the sum of equity and debt in the company. So a company with 20% ROE, but which has just as much debt as equity, will have a 10% ROFE. This metric is makes sure management aren’t inflating ROE by using excessive debt. It’s not just equity dollars that are used to generate profit, but also borrowed dollars. Managers should be getting a good return on both.
Net Profit to Interest Ratio: As a final check on corporate performance, net profit should be checked against the interest costs on borrowings. This ratio shows how exposed a company is to a movement in interest rates. Equity and debt levels may stay constant, but if rates move up quickly then borrowings become much more expensive and start eating into shareholder dividends.
If these three metrics are maintained within appropriate ranges (which will vary depending on the industry) then the company should perform well. As a result, shareholders we be rewarded as share price and dividends increase in line with the underlying strength of the company.
This approach would allow manager to lay legitimate claims to bonus pay whilst shareholders benefit from high returns. A classic win-win scenario (or “alignment” in management speak). It would also remove many methods of share price manipulation or “gaming” of current metrics that can be employed (consciously or sub-consciously) to boost bonus metrics.
Will it ever happen? I wouldn’t bet next month’s pay on it..