Sunday, December 14, 2008

How to assess executives

One of the greatest challenges faced by both boards and management teams is in effectively measuring and rewarding executive performance. Developments over the past decade have further heightened the focus on performance measurement issues, including an increase in the performance-bases long-term incentives plans and new disclosure rules, requiring a more detailed explanation of how compensation decisions are linked to performance results.

However, performance measurement systems must reflect each organization's unique industry dynamics, business strategy, and management style. Some common mistakes organizations make in measuring executive performance are :
  1. EPS is the primary driver of shareholder value: EPS is the most common metrics used in discussing corporate performance. Because it is easily understood by executives, widely accepted by investors and always reported by the press as an indicator of whether or not a company is successfully executing its business plans, many companies have adopted this measure for their executive incentive plans. In addition, we suspect more companies are considering broadly used metrics, such as EPS, in an attempt to avoid disclosing sensitive information about business plans when complying with disclosure rules.

    Despite its ubiquity, EPS has many shortcomings as the primary measure of business performance. As a performance measure, EPS

    • can be affected by changes in the accounting policy

    • does not account for the cost of capital and capital structure of the business

    • yeilds growth percentages that can be mileading when calculating growth from a small base (or from negative earnings)

    And most important, actual EPS performance (as opposed to performance against expectations) may not always be well-correlated with shareholder value creation. Some business leaders have even suggested that focusing on short-term EPS results can actually be harmful for long-term shareholder value creation. As a result some companies are abandoning quaterly, and even annual, guidance.

    Executive pay programmes should take cue from these trends and look beyond EPS for alternative or complementary metrics that are more closely related with long-term value creation and appropriately recognize unique organiazational characteristics such as asset intensity, industry and stage of market development. For example, capital intensive industries, such as manufacturing companies can better reward business results by incorporating measures that capture the cost of capital (for example, economic profit) to ensure that earnings provide a sufficient return on investment.

  2. TSR is the only performance metric you need: While EPS may not be well-correlated with shareholder value, no one will deny that TSR closely tracks investor experience. In addition, TSR data is readily available and transparent, which allows for the objective benchmarking of performance against peers.

    However, while executives can generally undrestand how their decisions impact EPS, the relationship between executive behaviour and TSR results is less direct. Issues with TSR or shareholdr appreciation plans include :

    • TSR is impacted by factors outside the control or influence of the management, including macroeconomic factors, broad market trends and specific sector competitive issues

    • TSR repersents actual performance and expectations for future performance; rewarding for TSR means rewarding for results that have not been delivered

    • Market movement typically lags financial, strategic and operational outcomes and may not appropriately reflect current actions that position the business for long-term success

    • Difficulty in communicating the plan and its potential value to participants

    So, although, TSR or share price appreciation can play a role in the performance measurement system, given the realities it should not be relied upon as the sole determinant of executive performance. The most effective incentive programmes will also include metrics that are directly linked to the business strategy, provide a clearer line of sight to executive behavior and measure outcomes (not expectations).

    A common design approach is to utilize a short-term incentive plan with specific financial, operational and strategic goals to complement a long-term plan based on TSR or share price appreciation. Even better, some organizations have adopted a long-term incentive plan that rewards both TSR and the achievement of long-term financial goals, such as the targeted level of return on capital. Performance share plans, which deliver a specifed number of common shares to executives at the end of a performance period depending upon performance against established criteria, can be particularly effective vehicles for rewarding both financial and market results.

  3. A balanced scorecard is the best framework for measuring performance: Scorecards, which measure results against a range of factors, are often used to paint a more holistic picture of performance outcomes than can be captured by one or two metrics.

    Yet "balanced" scorecards, which typically place equal weight on financial objectives and a host of other operational and strategic objectives, may not appropriately reflect your business priorities.

    Scorecards are often more effective if they are "unbalanced" as they provide greater flexibility to reflect the business strategy s it evolves.

    One variation of the "unbalanced" scorecard is to utilize a common framework of growth, operational profitability and market measures but to vary the metric weightings based on current business priorities. For example, a company that has recently weathered an industry slump by focusing intensely on profit margins could change its metric weightings as the market rebounds to effect a desired shift in focus from cost containment to growth.

    Another variation is to use a scorecard for allocating the bonus to business units or individuals while funding the incentive pool based on only those metrics that are deemed to be the most critical.
Regardless of the plan design, performance metrics should consider your company's specific strategy for achieving competitive advantage, as well as the factors that executives truly have the ability to influence.


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