Exec-proofing – Part 1 – Avoiding Companies That Suffer From Excessive Executive Pay

The raison d'être behind this approach is to ensure that we steer clear of companies that experience diminished shareholder returns when company executives and the board of directors work together to augment themselves as opposed to the company’s shareholders. Executive compensation and the excessive nature of it is a very complex topic and numerous factors guide executive compensation up at a much faster pace than that of rank-and-file workers on an average basis. Further, the base numbers are hundred-fold higher for executives as compared to average workers in corporations.

Below is a look at several popular alternatives for gauging executive pay and how they come up short when it comes to effectiveness. This is also an attempt to debunk several myths about executive compensation:

1. Let market forces determine the level of compensation: This alternative essentially makes the argument that there is no problem as market forces guide compensation. Should that be true, the counter point would be that the bigger and more profitable companies would always have at their helm the highest skilled CEO’s, a point that can easily be refuted.
2. CEO pay should parallel company performance: Getting paid a significant percentage from the earnings generated is presumably valid. However, there is a huge misunderstanding in such a thought process – the individual concerned usually owns a significant portion of the company’s outstanding shares making it possible for them to participate at that level on the company’s earnings anyway. Issuing salary commensurate with earnings or its growth there of is essentially double dipping on a very large scale. This is especially true when the CEO happens to be a founder.
3. Use the CEO’s track record as a measure of pay: While it is common for Wall Street to label CEO’s as “turnaround stars” and “growth stars” the problem is usually that such “stars” usually demand (and get) a premium that far exceeds the additional value that their track record brings to the company.
4. Compare the ratio of the average executive pay to the CEO compensation in the company: This is counter-intuitive as the executive team generally holds an unfair edge compared to rank and file workers. Therefore, in the companies that have a problem with excess compensation, it is highly likely to find a correlation where the other executives are also enjoying excessive compensation making it a bigger problem as far as shareholder value goes.

A gauge of executive compensation that makes a lot of sense to us is comparing CEO compensation with the average pay across the company - the higher that number, the more the company has a problem with excessive compensation. This gauge ignores such factors as the size of the company, profitability, and earnings growth but instead focuses on the disparity of pay. The main idea with this gauge is recognizing that, in an ideal world, all employees get to participate in the success of the company they work for, albeit on a scale that is commensurate with skill-level.

The gauge favors companies that encourage a career path that ends at the CEO level as opposed to hiring from outside - the SEC filings for the last five years can be used to come up with a figure for average annual CEO compensation and divide it with the average compensation of the rest of the employees in the company. Needless to say, such an exercise is time consuming to compile. A similar measure that has most of the characteristics of this but less difficult to compile is to compare CEO compensation with the average worker wage of roughly $20/hour.


Related Posts:

1. Exec-proofing – Part 1 – Avoiding Companies That Suffer From Excessive Executive Pay. 
2. Exec-proofing – Part 2 - Gauging Executive Compensation In The Companies in Our Portfolio.

Last Updated: 10/2008.