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MEASURING AND REWARDING PERFORMANCE: THEORY AND EVIDENCE IN RELATION TO EXECUTIVE COMPENSATION

A report prepared for the CFA Society of the UK

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OCTOBER 2014

Lars Helge Hass

Jiancheng Liu

Steven Young†

Zhifang Zhang

(Lancaster University Management School)

We are grateful for comments and guidance from the Steering Group for this project

– Natalie WinterFrost, James Cooke, Brian Main, Sheetal Radia, Mikkel Velin, and

Alasdair Wood. We are particularly grateful to Mikkel Velin and Rogge Global Partners

for providing advice and data to assist with cost of debt calculations. We would also

like to thank Martin Conyon for his comments and guidance. All views expressed

herein are the responsibility of the authors and do not necessarily reflect the views

of the CFA UK. Any remaining errors are the sole responsibility of the authors.

†Corresponding author: Tel: ++44 1524 594242. Email: [email protected].

Address: Lancaster University Management School, Lancaster University, Lancaster

LA1 4YX. Financial support was provided by the CFA UK.

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EXECUTIVE SUMMARY Debate surrounding executive compensation is an

enduring feature of the UK corporate landscape. While

concern over compensation levels continue to exercise

politicians, regulators, investors and the media, there is

growing concern over the degree to which performance

metrics commonly used in executive compensation

contracts represent appropriate measures of

long-term value creation. This debate partly reflects

fears that UK executives face excessive pressure to

deliver short-term results at the expense of long-term

improvements in value (e.g., Kay Review 2012).

This report contributes to the debate over executive

compensation generally and in particular to the

question of performance measure choice in executive

compensation contracts. The first part of the report

summarises key insights from the academic and

professional literatures regarding the structure of

executive compensation arrangements and the

metrics used to link pay with corporate performance.

The second part of the report presents findings from a

pilot study of executive compensation arrangements

and their association with corporate value creation

using a subsample of FTSE-100 companies.

Our synthesis of prior research provides the

following findings:

» Economic theory provides guidance on

compensation plan design and the importance of

linking rewards to observable outcomes. However,

while theory dictates that investment decisions

should be made on the basis of discounted cash

flows and the net present value rule, in theory it

offers little direct guidance on how to measure and

reward managerial performance;

» An effective performance measure should capture

whether management have generated adequate

returns to capital providers (both debt and equity

investors). Firms create value when they generate

economic profits, defined as returns that meet or

exceed the entity’s cost of capital. Economic

profits differ from accounting profits and returns

to equity holders because the latter metrics do not

include a periodic charge for the cost of invested

capital. Failure to benchmark periodic performance

against the opportunity cost of funds can lead to

misleading signals regarding the degree of periodic

value creation;

» In the absence of a first-best measure of periodic

performance, corporate boards and compensation

consultants employ metrics that yield the most

efficient second-best solution to the issue of

measuring and incentivising executive performance;

» Two features of current UK practice are particularly

striking: (i) the dominance of performance metrics

that capture returns to equity investors such as

earnings per share (EPS) and total shareholder return

(TSR) as opposed to entity-level metrics that capture

returns to all claimholders, and (ii) the dearth of

metrics such as residual income (RI) that benchmark

periodic performance against the cost of capital;

» Prevailing practice supports concerns expressed

by a range of corporate stakeholders that UK

corporate managers and boards may be failing to

recognise the crucial distinction between paying for

performance and compensating management for

strategic success.

» The unintended consequences of over-reliance on

narrow, simplistic performance metrics that align

poorly with value creation are well documented

and include: investment myopia, earnings

manipulation, excessive risk taking, and threats to

organisational culture.

» Much of the debate on the link between executive

pay and corporate performance continues to focus

on strengthening explicit links with conventional

performance metrics (e.g., EPS and TSR) rather than

on the issue of performance metric choice.

To shed further light on executive compensation

arrangements and the link between pay and value

creation, we report results for a pilot study examining

compensation and performance data over the period

2003-2013 for a sample of 30 FTSE-100 companies. Our

analysis seeks evidence on three questions:

1. What is the degree of alignment between alternative

measures of periodic performance, defined to include

both equity- and entity-level metrics?

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2. How does executive pay align with alternative

measures of periodic performance and in particular

with measures of value creation for all capital

providers?

3. How do performance metrics employed in

executive compensation plans align with the key

performance indicators that drive value at the

individual company level?

Our key empirical findings are summarised as follows:

» Consistent with extant evidence, we find that

EPS and TSR are the most commonly employed

performance metrics in CEO compensation contracts

throughout our sample period; value-based metrics

such as RI are rarely used;

» Performance metrics that are commonly used in

CEO compensation contracts (e.g., EPS, TSR and

ROE) display relatively low correlation (< 0.5) with (i)

free cash flows to all capital providers (FCF) and (ii)

returns to all capital providers in excess of the cost

of capital (RI);

» In relative terms, the correlation between CEO

compensation and both FCF and RI is at least as

strong as for contracted performance metrics

such as EPS and TSR (although findings for FCF are

sensitive to the specific definition employed);

» In absolute terms, CEO pay measured from a range

of perspectives also displays low correlation (< 0.3)

with firm performance regardless of the specific

performance metric employed;

» We find some evidence that high reliance on EPS

performance conditions may lead management to

pursue actions aimed at increasing short-term EPS

rather than enhancing long-term value creation.

Although our results are best interpreted as

suggestive given the small sample size, they are

nevertheless consistent with large-sample academic

research documenting similar effects;

» We report evidence consistent with a material

disconnect between KPIs disclosed by management

and the metrics used to incentivise and reward

senior executives. In particular, approximately

one third of cases display apparent misalignment

between the non-financial drivers of business value

and the performance metrics used to incentivise and

reward CEOs.

Our results provide some comfort but also create cause

for concern. On the positive side, results demonstrate

a material positive association between CEO pay

and several measures of value creation for all capital

providers. The evidence suggests that prevailing

executive pay structures incentivise and reward

important aspects of value creation even though

contractual performance metrics are not directly linked

with value creation in many cases. More troubling,

however, is our evidence that (i) a large fraction of CEO

pay appears unrelated to periodic value creation and

(ii) key aspects of compensation consistently correlate

with performance metrics such as TSR and EPS growth

where the direct link with value creation is more fragile.

Based on our findings we conclude that while

compensation practices in the UK have improved

significantly since Sir Richard Greenbury published

his landmark report in 1995, the journey is far from

complete. Both the explicit link (through performance

measure choice) and the implicit association (as

reflected in observed correlations) between CEO pay

and returns to all capital providers remain weak in

absolute terms. Moreover, since our analysis focuses

on the largest publicly traded firms that tend to

follow best-practice guidelines most assiduously, our

findings likely reflect an upper bound on the strength

of the link between executive pay and fundamental

value creation. We therefore view the issue of

performance metric choice in executive compensation

arrangements as work-in-progress and an area where

significant opportunities for further improvement exist.

INTRODUCTION Debate surrounding executive compensation is an

enduring feature of the UK corporate landscape.

While changes to disclosure rules and best practice

guidelines have led to significant improvements in the

transparency and structure of executive pay since the

mid-1990s, concern over both the level of pay and its

sensitivity to performance shows no sign of relenting.

From claims of fat cat pay deals for executives in the

utility sector that triggered the Greenbury Report (1995)

to recent outrage over bankers’ bonuses and their

potential role in the recent global financial crisis, the

structure and governance of executive compensation

arrangements continues to make the headlines.

While the overall quantum of executive compensation

and outrage over the magnitude of bonus payments

dominate much of the discussion, a more nuanced

debate focusing on the way performance is measured

and the extent to which commonly employed

performance metrics reflect long-term value creation

is starting to emerge (Young and O'Byrne 2001, The

Aspen Institute 2010, Deloitte 2010, PwC 2012, KPMG

2013, Towers Watson 2013). The debate is motivated

in large part by concern over the emphasis placed

on short-term performance outcomes and the

impact of such pressure on firm-level investment

decision-making and UK competitiveness more

generally. The Kay Review (2012), for example,

highlighted concern about the short-term orientation

of UK financial markets and corporate management,

while the High Pay Commission (2014) has expressed

concern that UK executives face short-term

decision-making pressure aimed at delivering quick

improvements in accounting returns rather than

improving underlying productivity and investing in the

long-term future of the company. As a result, the way

executive performance is measured and rewarded

is facing scrutiny from a range of financial market

stakeholders including the Department for Business,

Innovation and Skills (DBIS), the CFA Society of the UK

(CFA UK), the Association of British Insurers (ABI) and

the High Pay Commission, all of whom have expressed

doubt over the extent to which performance metrics

commonly used in executive compensation contracts

represent relevant and reliable measures of long-term

value creation.

This report comprises two parts. Part A synthesizes

the academic and professional evidence regarding the

structure of executive compensation arrangements,

with particular focus on the metrics used to link

executive pay to corporate performance. For the

purpose of our analysis, executives are defined

narrowly to include the Chief Executive Officer (CEO)

and other board-level members of the executive team

(e.g., the Finance Director). Part B presents empirical

results on executive compensation plan design and

links with value creation for a representative sample

of FTSE-100 companies with data for the period 2003

to 2013.

1 Murphy and Zábojník (2007) and Frydman (2006) examine the rise in CEO pay and provide general equilibrium models attributing increases to a growth in external hiring. Both studies argue that demand for CEO talent has shifted from firm-specific skills (i.e., knowledge, contacts, and experience valuable only within the organization) to general managerial human capital (i.e., human capital specific to CEO positions). A consequence of this shift is more external CEO hires, which in turn has increased equilibrium average CEO pay relative to the pay of lower-level workers. Meanwhile, Kaplan and Rauh (2010) compare compensation increases among other talented and fortunate groups (financial service sector employees, corporate lawyers, professional athletes and celebrities) to examine whether the growth in CEO pay reflects market forces. They conclude that growth in CEO pay is not a sign of suboptimal contracting but rather a consequence of market forces that contribute to general wage inflation among high paid professionals.


PART 1:

LITERATURE REVIEW AND CRITIQUEWe begin by reviewing the structure of executive pay

arrangements in the UK and the regulatory system

in which CEO pay is governed. Section 3 reviews

key theoretical insights concerning pay structures,

including the demand for performance-based

compensation in a traditional principal-agent setting,

the need for compensation arrangements that balance

the demand for short-term results against the need for

long-term value creation, the importance of aligning

executives’ and shareholders’ risk preferences, and

the use of relative performance evaluation. While

the majority of theoretical work in this area focuses

on agency problems between managers and

shareholders, section 4 reviews the small body of work

examining the link between executive compensation

plan design and capital structure.

Consistent with our focus on performance

measurement, section 5 reviews the properties of

a range of performance metrics including share

returns, cash flows, earnings, and economic profits.

Advantages and disadvantages associated with

each category are discussed. In section 6 we review

theory and evidence on the choice between alternative

performance metrics. Section 7 reviews evidence from

academic research and professional surveys regarding

the performance metrics to which CEO pay is linked.

A striking feature of the analysis is the dominance of

unsophisticated measures of periodic performance

such as earnings per share and total shareholder return

that (i) focus exclusively on returns to shareholders and

(ii) ignore the cost of capital.

A vast body of research highlights the dangers of

using inappropriate metrics to measure and reward

managerial performance. Section 8 synthesizes

evidence on the unintended consequences of

performance-related pay including investment

myopia, earnings manipulation, excessive risk

taking, and threats to organisational culture. This

section also presents a brief overview of research

examining the role of executive compensation in

the recent global financial crisis. Section 9 critiques

the prevailing approach to measuring and rewarding

executive performance, and seeks to understand

how such apparently flawed systems can persist

in equilibrium. Section 10 reviews the emerging

trend toward linking executive pay more closely to

corporate strategic priorities and key business drivers.

Section 11 concludes.

2 CONTEXT AND INSTITUTIONAL SETTINGThis section provides a brief overview of compensation

arrangements for CEOs and other senior executives

of the largest companies listed on the London Stock

Exchange, together with a brief summary of the

institutional and regulatory parameters in which

executive compensation is determined.

2.1 OVERVIEW OF PAY LEVELS AND COMPENSATION STRUCTURE

Median total executive pay for FTSE 100 (250) CEOs

in 2013 including benefits but excluding pensions

was £3.2 (£1.3) million (KPMG 2013), with main board

members receiving approximately half as much (PwC

2012). Median total remuneration of FTSE 100 CEOs

(including pensions) rose from of £1m to £4.2m for the

period 1998-2010, equivalent to an average annual rise

of almost 14 percent (DBIS 2011). This rate of increase

outstripped growth in the FTSE 100 index, retail prices,

and average pay rises for other employees over the

comparable period (DBIS 2011, Farmer et al. 2013). 1

Annual CEO pay growth is positively correlated with firm

size: increases are highest among FTSE 100 companies,

followed by FTSE 250 companies, with Small Cap and

Alternative Investment Market companies reporting

the lowest increases in relative terms (DBIS 2011: 8).

Despite these large pay increases, UK CEOs earn less in

absolute terms than their U.S. counterparts even after

controlling for firm size, industry and other managerial

characteristics, although the gap diminishes

significantly after controlling for risk (Conyon et al.

2013, Conyon et al. 2011). Analysis of annual average

increases in CEO compensation reveals a plateauing

of pay growth from 2008 onwards (PwC 2012, KPMG

2013), consistent with attitudes and behaviours

changing as a consequence of increased scrutiny from

shareholders, Government, regulators, and the media

over recent years (PwC 2013).

The typical executive compensation package for FTSE

350 firms comprises the following four components

(PwC 2012, Conyon et al. 2013, KPMG 2013):

» Salary: Annual salary represents the fixed component

of pay. The median CEO salary among FTSE 100 (250)

companies in 2013 was approximately £850,000

(£465,000), representing 26 (36) percent of total

pay inclusive of benefits (KPMG 2013). In response

to growing pressure to link pay with performance,

salary as a fraction of total compensation has

declined monotonically from approximately 40

percent in 1998 (DBIS 2011). However, despite

accounting for an increasingly small fraction of total

compensation, base salary remains a key element of

CEO pay because performance-related elements of

pay are typically defined as a multiple of base salary

(Murphy 1999).

» Annual bonus: Bonus plans provide executives

with incentives to improve short-term corporate

performance. In a typical short-term bonus plan, the

executive is entitled to rewards that increase linearly

over a predefined performance range that is limited

by upper and lower bounds. The median maximum

bonus payable for FTSE 100 (250) CEOs in 2013 was

190 (125) percent of salary, while the median actual

bonus paid was 119 (93) percent of salary (KPMG

2013). An increasingly large number of UK companies

either require or permit a significant fraction of the

annual bonus (normally 50 percent) to be paid in

shares and deferred for several years. Where deferral

is voluntary, many companies award executives

additional matching shares subject to supplementary

performance conditions.

» Equity incentives: Share-based incentives are

designed to encourage executives to focus on

long-term performance. The two most common forms

of equity incentives are share options and restricted

stock [also known variously as performance share

plans (PSPs) and long-term incentive plans (LTIPs)].

Both approaches link executive rewards to share

price performance over a defined range with

the aim of motivating CEOs to make value added

investments. Individual payoffs are deferred until

the end of a predefined vesting period (typically

three years), thereby further increasing executives’

longer-term focus. Share options were the dominant

form of share-based incentives until the mid-2000s

in the UK, after which point a series of regulatory

changes tipped the balance toward restricted stock.

Following recommendations in the Greenbury Report

(1995), both option and restricted stock vesting is

conditional on satisfying additional performance

conditions. In 2013, the median face value of share

option grants (restricted stock awards) for FTSE 100

CEOs was 250 (200) percent of salary (KPMG 2013).

Corresponding amounts for FTSE 250 CEOs were 205

and 150 percent, respectively.

» Other forms of pay: Pensions and other benefits

(e.g., health care) comprise the residual elements

of executive compensation. Consistent with claims

that these elements present important sources of

compensation for executives (Frydman and Jenter

2010), DBIS (2011) report that pension payments

represent more than 10 percent of total annual

compensation for U.S. executives. Other benefits

tend to be immaterial as a fraction of total pay.

2.2 THE UK INSTITUTIONAL SETTING GOVERNING EXECUTIVE COMPENSATION

The UK regulatory approach to executive compensation

revolves round a “comply or explain” philosophy that

allows firms to deviate from best practice guidelines

and prevailing norms when company-specific

conditions demand.

New disclosure regulations were introduced for

companies listed on the London Stock Exchange

with financial years ending on or after 30 September

2013. The structure of the new reporting regulation

involves the following three core elements: (i) an annual

statement from the Chairman of the remuneration

committee, (ii) an annual report on remuneration

including details of payments made to directors and

information on arrangements for the next financial

period, and (iii) a report detailing remuneration policy.

Compensation policy will also be subject to a binding

vote, applicable for financial years beginning on or

after 1 October 2014. The anticipated impact of the new

regulations remains unclear. A KPMG (2013) survey of

companies and shareholders conducted in June 2013

reported that 39 percent of respondents believed the

2 PwC (2012) report that the most popular means of implementing claw-back is to scale-back vesting.

3 In the traditional property rights version of the agency literature, the principal’s desire to minimize agency problems drives the demand for compensation contracts. Jensen and Meckling (1976) extend the traditional agency model by demonstrating that in a rational expectations setting shareholders do not lose, on average, from managerial perk consumption and shirking (because shareholders rationally anticipate such behaviour and price protect). Instead, the full cost of expected non-value-maximizing behaviour is born by management and as a consequence the demand for compensation contracts is driven by management as a monitoring and bonding mechanism aimed at convincing the market to expect less perk consumption and shirking.


regulations would make no difference, whereas the

majority of respondents to a PwC (2013) survey of 40

large firms concluded that the new regulations will have

an effect, at least in the short run.

Following the Walker Review (2009) and the application

of internationally agreed standards for remuneration

in the financial services sector, the Financial Services

Authority Remuneration Code for financial institutions

required provision to be made for claw-back where

performance turns out to have been miscalculated or

misstated. The UK Corporate Governance Code was

subsequently amended in 2010 to include the proposal

that “consideration is given to the use of provisions that

permit the company to reclaim variable components

in exceptional circumstances of misstatement or

misconduct”. Claw-backs are gaining in popularity

following shareholder best practice guidance advising

firms to consider their remuneration arrangements and

outcomes in the context of business risk. PwC (2012)

report that 50 (25) percent of FTSE 350 firms have

introduced or are considering introducing claw-backs

for annual rewards (long-term incentives) in the event

of any short-term misstatement of performance or

individual misconduct. 2

3 THEORETICAL FRAMEWORKSThis section reviews a variety of theoretical results

and insights on executive compensation including the

demand for compensation contracts that link pay to

firm performance, the need to align executives’ and

shareholders’ risk preferences, the need for incentive

mechanisms that balance short-term performance

pressures against long-term value creation, and the

role of relative performance evaluation.

3.1 AGENCY THEORY AND THE DEMAND FOR PERFORMANCE-RELATED PAY

Mainstream academic research on executive

compensation has its roots in agency theory (Berle

and Means 1932, Ross 1973, Jensen and Meckling

1976, Holmstrom 1979 and 1982, Fama 1980, Lazear

and Rosen 1981, Grossman and Hart 1983). Within this

framework, compensation plans are designed to align

the interests of a risk-averse, self-interested agent (the

executive) with the interests of a risk neutral principal

(the owner). The resulting principal-agent models study

the trade-off between risk sharing and incentives in the

design of optimal compensation contracts. Effective

compensation plan design is predicted to play a central

role in value creation by resolving agency problems

associated with attracting, retaining, and motivating

professional managers (Murphy 1999).

The traditional set-up of principal-agent models

involves a risk-averse agent taking unobservable

actions that influence the statistical distribution over

observable performance measures. At the heart of

the theory is the notion of moral hazard, defined as

actions taken by the agent that are inconsistent with

the interests of the principal. Moral hazard problems

take many forms including prerequisite consumption,

shirking, and inappropriate risk taking behaviour.

The majority of moral hazard models typically assume

that the principal and agent have homogeneous

information at the inception of the contract but that

during the contracting period the principal is unable

to cost-effectively observe all the agent’s actions.

Unobservable actions combined with the agent’s risk

aversion results in a second best contracting solution

that involves the principal trading-off her desire to

provide appropriate incentives against the risk premium

that must be paid to the agent as compensation for

bearing the additional risk imposed by the contract.

The principal uses performance measures that are

observable ex post to design an ex ante efficient

incentive contract that will induce the agent to take

desired action(s). 3

The key insight emerging from early theoretical work

is that the optimal compensation scheme is a linear

function of observable measures of performance

such as profits or revenue (Holmstrom 1979 and 1982,

Grossman and Hart 1983, Holmstrom and Milgrom 1987).

This result forms the basis for more advanced models

that develop richer insights regarding contract design.

For example, Cao and Wang (2013) integrate search

theory into an agency framework to study executive

compensation in a market equilibrium. Their model

distinguishes idiosyncratic risk from systematic risk,

assumes that an executive can choose to stay or quit

and search after privately observing an idiosyncratic

shock, and that the market equilibrium endogenizes

executives’ and firms’ outside options and captures

contracting externalities. Findings demonstrate that

the equilibrium sensitivity of the executive’s pay to

firm performance and the ratio of the executive’s total

compensation to firm value are positively (negatively)

correlated with idiosyncratic (systematic) risk.

Empirically, studies employing a range of different

approaches to measure the association between

executive pay and firm performance provide consistent

evidence that the pay-performance link appears weak

in both absolute terms and relative to the predictions

from principal-agent models (Jensen and Murphy

1990, Hall and Liebman 1998, Core and Guay 2002a,

Frydman and Jenter 2010). For example, using data

for 309 UK non-financial firms from the FTSE All Share

Index between 1995 and 2005, Ozkan (2011) concludes

that the pay-performance elasticity for UK executives

is low in both absolute and relative terms. In absolute

terms, a 10 percent increase in shareholder return

increases cash and total direct compensation by 0.75

percent and 0.95 percent, respectively. In relative

terms, these sensitivities are significantly lower than

comparable results documented for U.S. executives.

Further evidence suggests that the pay-performance

relationship is asymmetric, with executives being

rewarded for positive shocks and shielded from

negative shocks (Gaver and Gaver 1998, Bertand and

Mullainathan 2001).

3.2 ALIGNING RISK PREFERENCES

The standard agency model involves risk neutral

shareholders and risk averse executives. Incentivising

management to make investments consistent with

owners’ risk orientation is therefore a key objective of

effective compensation plan design. Share options

play a central role in aligning risk preferences. Options

introduce convexity in the executive payoff function:

executives are rewarded for share-price appreciation

above the exercise price but are not penalised when

share price falls below the exercise price. 4 Convexity

helps mitigate executive risk aversion insofar as the

value of the option to the holder is increasing in share

price volatility. The positive relationship between option

value and share price volatility creates incentives

for management to seek out risky projects. Knopf

et al. (2002) and Armstrong and Vashishtha (2012)

report evidence of a positive association between

executive option vegas (the sensitivity of share

option value to share price volatility) and executive

risk-taking behaviour.

However, the impact of share options is not limited to

volatility effects that promote risk taking behaviour.

Offsetting effects that reduce executives’ risk taking

incentives are also embedded in the standard share

option plan. In particular, the positive association

between option value and share price performance

when options are in the money, incentivises

management to eschew risky investments that

threaten share price performance in the short run

(Knopf et al. 2002, Ross 2004). Empirical evidence

confirms the presence of a negative association

between executive option portfolio deltas (the

sensitivity of option value to share price performance)

and executive risk taking behavior (Knopf et al. 2002,

Carpenter 2000).

Notwithstanding the central role that risk plays in

agency theory, Wiseman and Gomez-Mejia (1998)

contend that the standard formulation of risk in agency

models is too restrictive for several reasons. First, by

assuming principals (agents) to be risk neutral (risk

averse), the framework overlooks well established traits

such as risk-seeking or risk-loving behaviour (e.g., Piron

and Smith 1995). Second, agency models assume risk

preferences remain stable over time, which contradicts

behavioural decision theory (Kahneman and Tversky

1979). Third, agency theory treatments of risk and

performance are typically linear and recursive, whereas

insights from other literatures suggest more complex

associations between performance and individuals’ risk

choices (Kahneman and Tversky 1979).

In response, Wiseman and Gomez-Mejia (1998) develop

a behavioural agency framework that combines

insights from prospect theory (Kahneman and Tversky

1979) and agency theory to better explain executives’

choices with respect to strategic risk. The resulting

model suggests that executive risk taking varies across

different forms of monitoring, and that agents may

exhibit risk-seeking as well as risk-averse behaviour.

4 Annual bonus plans have similar characteristics. Bonus payments are a linear function of performance above the minimum performance threshold required to trigger payouts but executives do not face “negative bonuses” as performance declines below the threshold level.

5 Holmstrom’s (1982) analysis also implies that competition among agents has merit solely as a device to extract information optimally, and that competition per se is worthless. As such, his findings cast doubt on the incremental incentive value of tournament schemes that tie compensation outcomes to an agent’s observable performance (Baiman and Demski 1980; Lazear and Rosen 1981).


Notable insights emerging from the model include: the

prediction that unexercised positively valued share

options create risk bearing for the agent leading to an

increase in executive risk aversion; the prediction that

high variable-pay targets increase executive risk taking

by increasing the probability that they will face a loss

decision context; and the proposition that reliance on

external market-based (internal accounting-based)

performance criteria increases the probability of a

loss (gain) decision context and therefore ultimately

increases (decreases) executive risk taking.

3.3 BALANCING LONG- AND SHORT-TERM PERFORMANCE PRESSURES

Investment myopia occurs when executives take

actions (either opportunistically or in good faith) that

increase short-term performance at the expense of

long-term value creation. Examples of myopia include

cutting back on discretionary investment expenditures

such as research and development, advertising, and

employee training in effort to increase short-term

earnings performance at the expense of positive

future returns, sale-and-leaseback transactions that

increase accounting returns despite violating the net

present value (NPV) rule, failure to replace aging assets

that have been fully depreciated, disposing of positive

NPV assets to increase short-run earnings, and share

repurchases to increase short-run earnings per share

(Bens et al., 2002, Hribar et al. 2006, Young and Yang 2011).

Theory demonstrates that executive compensation

contracts can play an important role in mitigating

short-termism. For example, a large body of theoretical

work predicts that firms whose value is largely

determined by growth options are expected to use a

higher fraction of long-term incentives (e.g., stock options

and restricted stock) to counteract risk of managerial

myopia (Smith and Watts 1992, Bizjak et al. 1993, Gaver

and Gaver 1995). More recently, Edmans et al. (2012)

consider optimal compensation in a dynamic framework

where executives consume in each period, save

privately, and temporarily inflate returns. The resulting

optimal contract ensures the executive not only exerts

effort in the current period but also has sufficient equity

in future periods to sustain their effort and avoid myopia.

Findings provide guidance on how compensation

arrangements might be reformed to address problems

including short-termism (Kay Review 2012) and weak

incentives resulting from large stock price declines.

While the model developed by Edmans et al. (2012)

assumes the executive remains with the firm for a fixed

period, Bolton and Dewatripont (2005) demonstrate

how resignation risk significantly complicates

intertemporal risk-sharing arrangements because

the agent may leave the firm where she does not see

a high continuation wealth for herself. Conversely,

DeMarzo and Sannikov (2006) and DeMarzo and

Fishman (2007) develop risk-neutral models in which

contract termination provides an extra source of

incentives to the executive.

3.4 RELATIVE PERFORMANCE EVALUATION

Holmstrom (1982) introduces the notion of relative

performance evaluation (RPE). The key theoretical

insight from his model is that RPE is valuable where

one agent’s output provides information about another

agent’s state uncertainty (i.e., where uncertainties

faced by both executives are common). Incorporating

performance of agents exposed to similar uncertainties

into the compensation contract permits common

uncertainties to be filtered out, thereby shielding

executives from the effects of systematic risk and

avoiding owners overpaying for performance beyond

executives’ control. 5

Despite the theoretical appeal of RPE, many empirical

studies fail to provide consistent evidence supporting

its use (Antle and Smith 1986, Gibbons and Murphy

1990, Janakiraman et al. 1992, Aggarwal and Samwick

1999; Garvey and Milbourn 2003, 2006; Rajgopal

et al. 2006, Albuquerue 2009). One explanation for

these inconsistent findings is the indirect nature of

the empirical analyses, which often test for RPE by

examining the correlation between executive pay and

industry- or market-level measures of performance.

Accordingly, these studies ignore potentially important

elements associated with RPE contracts including

peer group composition, performance metrics, and

components of pay covered by RPE (Gong et al. 2011).

Recent research using mandated compensation

disclosures in the UK and U.S. suggest widespread use

of RPE provisions in executive compensation contracts

(Gong et al. 2011, Carter et al. 2009).

4 EXECUTIVE COMPENSATION AND CAPITAL STRUCTUREThe agency theory perspective on executive

compensation contract design emphasises conflicts

of interest between shareholders and senior

management. However, firms’ external claims are

not limited to equity. Jensen and Meckling (1976)

demonstrate that conditions resulting in moral hazard

and incomplete contracting between management and

shareholders also lead to moral hazard in contractual

relations between shareholders and other external

claimholders such as suppliers of debt capital.

However, despite apparently important linkages

between executive incentives and capital structure, the

majority of academic research examines these issues

separately. For example, seminal contributions by

Mirrlees (1976) and Holmstrom (1979) explore executive

compensation contract design in a principal-agent

framework that abstracts from capital structure

considerations, while agency models of capital

structure such as Jensen and Meckling (1976) and

Grossman and Hart (1983) do not consider managerial

compensation explicitly.

A small body of literature explores the link between

executive compensation plan design and capital

structure (Brander and Poitevin 1992, John and John

1993, Ortiz-Molina 2007). The primary insight from

this work is that optimal executive compensation

arrangements depend on not only the agency

relationship between shareholders and management

but also on conflicts of interest involving creditors.

Theory demonstrates that compensation contracts

cannot be structured to minimise the agency

costs of equity alone since there are agency

costs resulting from contractual relationships

with other external claimants including creditors.

Specifically, in the presence of risky debt, contractual

arrangements designed to minimise the agency

costs of equity by aligning managerial incentives

with shareholders’ interests can create incentives for

management to choose suboptimally risky investment

policies that benefit shareholders at the expense of

bondholders (Jensen and Meckling 1976). This problem,

which is often referred to as risk-shifting, creates

agency costs of debt finance because rational lenders

price debt securities taking into account managers

inferior risk choices.

Aligning executive compensation more closely with

total cash flows to the entity (rather than exclusively

with returns to shareholders) helps limit agency

costs of debt because rational lenders anticipate

executives’ superior risk choices and reduce their

required return. As residual claimants, shareholders

also gain from lower debt costs. An important

implication of this agency-costs-of-debt perspective

is that executive pay-performance sensitivity and

leverage are negatively correlated as entities with

risky debt surrender a degree of pay-performance

alignment with shareholders to reduce overall

agency costs and increase firm value. John and John

(1993) also use this insight to explain the apparent

inconsistency between the implications of formal

principal-agent models (which predict high sensitivity

of executive pay to observable performance) and

empirical evidence on executive compensation

realisations (which reveals surprisingly low

pay-performance sensitivities in practice).

An alternative (non-exclusive) explanation supporting

a negative relation between leverage and the

sensitivity of executive compensation to shareholder

returns is based on the monitoring benefits of debt.

The free cash flow hypothesis predicts that the

requirement to service debt payments reduces free

cash flow available to management and creates

powerful incentives for managers to focus on

value maximisation aimed at avoiding bankruptcy

costs (Grossman and Hart 1983, Jensen 1986). The

monitoring benefits associated with higher debt levels

may substitute for high-powered pay-performance

compensation incentives, leading to an equilibrium in

which highly levered firms are associated with lower

pay-performance sensitivity. Ortiz-Molina (2007) labels

this view the monitoring substitutes hypothesis.

Consistent with theory, several studies document that

the sensitivity of executive pay-to-shareholder wealth

is decreasing in leverage (Gilson and Vetsuypens

1993; Ortiz-Molina 2007). Ortiz-Molina (2007) seeks

to distinguish between the competing theoretical

arguments supporting this negative association. While

he finds some support for the monitoring substitutes

hypothesis, he concludes that the evidence is more

consistent with the agency-costs-of-debt explanation.

In particular, Ortiz-Molina (2007) finds the negative

association between leverage and pay-performance

sensitivity is especially pronounced for the option

6 Investors value information resolving uncertainty associated with risky projects. As such, investors’ preference in processing information is likely to distort share price as a performance measure, even assuming the efficient market hypothesis holds [because share prices are noisy and fluctuate around a true (intrinsic) value].

7 In particular, investors care about the extent to which a performance measure resolves uncertainty about the firm’s ultimate payoff, whereas from a contracting perspective the principal is interested in degree to which the performance measure captures the agent’s unobservable effort.


component of executive pay, where the incentives for

risk taking (and hence the agency costs of risk-shifting)

are particularly acute.

While the negative association between leverage

and pay-performance is consistent with an

agency-costs-of-debt interpretation, the evidence is

nevertheless indirect. As Conyon et al. (2013) stress,

although the risk-taking incentives associated with

debt are conceptually indisputable, no conclusive

evidence exists to suggest that executives in highly

leveraged firms actually take larger risks than their

counterparts in less leveraged firms. Furthermore,

Conyon et al. (2013) argue that any association

between risk taking and debt is unlikely to be

monotonic. Whereas executives in highly leveraged

firms might consider suboptimally large risks where

the downside cost is largely borne by debtholders,

they are also likely to avoid taking small risks that

trigger technical or actual covenant default (because

the costs associated with loss of control and financial

distress are likely to be large compared to the small

amount of costs passed on to debtholders.)

5 MEASURING PERIODIC PERFORMANCE AND VALUE CREATION The property rights and principal-agent literatures

provide important insights regarding compensation

plan design and the importance of linking rewards to

observable outcomes. However, theory offers little

guidance regarding the practicalities of measuring

economic outcomes and the choice of specific metrics

against which managerial performance should be

judged and rewarded.

While finance theory dictates that investment decisions

should be made on the basis of discounted cash flows

and the NPV rule, periodic performance measurement

poses challenges for which economic theory

provides only limited guidance. Three fundamental

challenges exist with respect to periodic performance

measurement in a compensation contracting setting

(Feltham and Xie 1994). First, the actions and strategies

of the executive are not directly observable and as a

result she cannot be compensated directly for her input

into the firm. Second, observed outcomes are likely to

have been influenced by events from either internal or

external sources that lie outside the executive’s span

of control. Third, the full consequences of executives’

actions are not directly observable because the impact

of those actions can extend over several (many)

periods. This multi-period nature of performance

measurement serves to highlight the distinction

between measures of long-term value creation that

capture the full cash flow impact of investment

decisions versus periodic performance metrics that

capture a discrete slice of total performance.

At the heart of the performance measurement

problem is the need to discriminate between value

increasing actions and value destroying behaviour.

More generally, an effective performance measure

should capture whether management have generated

adequate returns on the resources at their disposal,

while also ensuring executives make appropriate

investment decisions (i.e., invest in additional resources

only when such investments produce an adequate

return and divest existing assets that are not yielding

an adequate return). Firms create value when they

generate economic profits, defined as returns that

meet or exceed the entity’s cost of capital. Economic

profits differ from accounting profits or raw market

returns because the latter metrics do not include

a periodic charge for the cost of invested capital.

Failure to benchmark periodic performance against

the opportunity cost of funds can lead to misleading

signals regarding the degree of value creation during

the measurement period.

The pool of available performance metrics includes

market-based information (e.g., stock price), cash

flows (e.g., operating cash flow and free cash flow),

accounting-based information (e.g., earnings and

return on investment ratios), value-based information

(e.g., economic profit), and non-financial information

(e.g., market share, consumer satisfaction). The

following sections review the properties of financial

performance measures. (A discussion of non-financial

and qualitative performance measures is presented in

section 6.)

5.1 MARKET-BASED METRICS

Share price performance is an obvious starting point

for assessing firm performance and value creation.

Although share price and total shareholder return

(TSR) may intuitively appear to be a necessary and

sufficient performance measure for publicly traded

firms to contract on for incentive purposes, Paul

(1992) highlights the problems of using share price

as the sole performance measure when designing

compensation contracts. First, share price tends to

overemphasise information about risky projects. 6

Second, share prices aggregate relevant information

inefficiently for compensation purposes. In particular,

share prices are forward-looking and therefore lead

to compensation for expected rather than delivered

performance (Venanzi 2010). Third, share price reflects

market-wide influences, thereby exposing executives

to factors beyond their control (Sloan 1993). While share

price captures factors that are unquestionably relevant

for firm value, many of these factors may have little to

do with executives’ contribution to value. Consistent

with this view, research demonstrates that the optimal

weights on information from a valuation perspective

are not necessarily the same as the optimal weights

for stewardship and incentive alignment (Gjesdal 1981,

Paul 1992). 7 Lambert (1993) further expands on this

insight by arguing that the task of firm valuation is not

equivalent to the task of evaluating an executive’s

contribution to firm value.

Further, equity market prices can deviate from

fundamentals for a variety of reasons ranging from

economic considerations such as limitations to

arbitrage (Shleifer and Vishny 1997) to behavioural

considerations including sentiment and “animal spirits”

(Akerlof and Shiller 2009). In addition, Sloan (1996, 2006)

demonstrates that markets are slower to incorporate

the full implications of periodic performance measures

than traditional efficiency views might suggest.

Management may also seek to engage in a range

of “financial shenanigans” (Schilit 2002) aimed at

presenting an excessively positive representation of

periodic performance and artificially inflating share

price in the short run. Although investors often see

through such behaviour, research demonstrates

that short-run mispricing can occur in response to

opportunistic reporting (Xie 2001).

5.2 CASH FLOW

Cash flows represent a theoretically appropriate

alternative to share price as a measure of performance.

Cash flows also enjoy strong intuitive support because

all investment returns ultimately boil down to cash

realisations and hence the view that “cash is king”.

Theory and practice highlights free cash flow (FCF) to

the firm as the appropriate cash flow measure from

a (long-term) valuation perspective, and therefore

using the same cash flows to assess short-term

performance appears a natural choice. Conceptually,

FCF represents residual cash flows generated by the

operating part of the business (i.e., cash earnings less

investment) that are paid to the financing component

of the entity (Penman 2001, Mauboussin 2006). More

formally, FCF is defined as cash earnings (sales plus

operating margin less cash taxes) minus investment

(change in working capital plus capital expenditures

plus net acquisitions), and as such represent cash

flows to all claimholders that provide finance to the

entity. Mauboussin (2006) presents a shorthand

approximation for FCF as:

FCF = NOPAT – Investment,

where NOPAT equals net operating profit after tax,

although the reconciliation is not so straightforward in

practice, particularly when investment takes the form

of intangible assets that show up as period expenses

rather than balance sheet assets.

Since FCF measures cash flows to all providers

finance, it represents a theoretically sound basis

for firm valuation. Consistent with other cash flow

measures, FCF is also considered to provide a reliable

indication of firm performance for several reasons.

First, the measure excludes allocations of historic costs

(accrual) and is therefore less susceptible than profit to

accounting manipulations or arbitrary accrual choices.

Second, FCF is less vulnerable than share price to the

impact of factors outside executives’ control.

Nevertheless, FCF suffers from the timing and

mismatching problems inherent in all cash flow

measures that create a periodic disconnect

between value-relevant actions and events, and the

corresponding cash inflows and outflows. Specifically,

cash flows do not necessarily follow economic events

in a timely manner, leading to a potentially weak link

with value creation when measured over short intervals

(e.g., 12 months). Dechow (1994) confirms that the

correlation between various cash flow metrics and

8 Earnings derived using generally accepted accounting principles (GAAP) include transitory and non-cash items that have few implications for future performance. Management and equity analysts often rely on non-GAAP earnings definitions (also known as pro forma or “street” earnings) that adjust reported net income for the effect of transitory items and certain non-cash adjustments. On average, these non-GAAP earnings metrics are more informative about periodic performance than the corresponding GAAP measure. However, adjustments to GAAP earnings made by management have also been linked with manipulation. [See Young (2014) for a review of the literature on non-GAAP earnings.]

9 This weakness is not unique to earnings; it applies to any periodic performance metric that is scaled by a measure of firm size over which management is able to exercise a degree of control. However, since scaling is more common for earnings-based measures of performance the problem tends to be more acute in this context

10 From an equity perspective, residual income is defined as net income for shareholders less the product of shareholders’ equity and the cost of equity.

11 Variable annual cash flows creates the possibility of management favouring projects with high RIs in the early years but yielding lower NPVs than competing projects where a larger fraction of RI is delivered in later years. In such cases, discounting RIs over the life of the project is the only to ensure investment decisions consistent with the NPV rule.


changes in firm value (share price) weakens as the

performance window narrows.

5.3 ACCOUNTING EARNINGS

Profit evolved as a solution to the timing and

mismatching problems inherent in cash flow. Earnings

adjust cash flows (through the accrual process) in

an effort to recognise the impact of economic events

occurring during the reporting period:

Earnings = Cash flow + Net accounting accruals

A range of different earnings metrics are available

depending on the level of aggregation required (e.g.,

the degree to which transitory items are included) and

whether periodic performance is being assessed from

an entity or equity perspective. 8

An extensive body of academic research demonstrates

that, on average, reported earnings are more highly

correlated with quarterly and annual changes in value

(measured using share returns) than periodic cash

flow, and better able to predict future operating cash

flows. [See Dechow (1994) and Dechow and Schrand

(2004) for evidence and further discussion.] In addition,

compared with share prices, accounting numbers are

less influenced by factors beyond managers’ control.

Accounting numbers therefore have the potential to

shield managers from the effects of uncontrollable

factors that affect share price (Sloan 1993).

Despite these benefits, accounting earnings are

characterised by several important weaknesses. First,

short-term earnings growth is imperfectly correlated

with long-term value creation. While the importance

attributed by investors to EPS leads many to conclude

that EPS growth dictates value, the fact that earnings

fail to explicitly account for capital intensity means

that two firms can report identical EPS growth rates

and yet if they have different return on invested

capital, they will naturally attract different valuations.

Mauboussin (2006) summarises the link between

earnings growth, return on capital, and value creation.

Earnings growth has a positive impact on value when

the firm’s return on capital exceeds its cost of capital.

In such circumstances, earnings growth and value

creation are aligned: rewarding earnings growth is

consistent with rewarding value generation. In contrast,

earnings growth has no effect on value where the

firm’s return on capital equals its cost of capital; and

for firms whose return on capital is lower than the cost

of funds, positive earnings growth serves to destroy

value. These two latter situations highlight the potential

folly of relying on (incentivising) earnings growth: in

extreme cases, emphasising earnings growth can lead

to overinvestment and value reduction (Brealey et al.

2008).

Second, earnings are subject to inaccuracy and

subjectivity as a result of the accrual process.

Research demonstrates that earnings quality (i.e., the

ability to forecast future performance or estimated

value) is decreasing in the relative magnitude of the

accrual component. High accruals provide executives

with more opportunities to manipulate reported results,

particularly in response to compensation-related

incentives (Healy 1985, Holthausen et al. 1995,

Bergstrasser and Philiponn 2006). (See section 8.2

for a more detailed treatment of the literature linked

earnings management with compensation plan

design.) Third, accounting typically treats investment

in intangible assets and growth options as a period

expense, thereby increasing the risk of managers

cutting value-increasing investment spending to boost

short-term accounting earnings (Dechow and Sloan

1991, Bushee 1998, Graham et al. 2005).

In recognition of the problems associated with using

profit to measure periodic performance in situations

where management can influence the asset base

(Otley et al. 1990), earnings are often scaled by

a measure of invested capital to produce return

investment metrics such as return on assets (ROA)

and return on equity (ROE). Unfortunately, because

short-term improvements in such ratios can be

achieved through reductions in the denominator as well

as increases in the numerator, return on investment

ratios can incentivise managers to make dysfunctional

investment decisions such as rejecting positive NPV

projects whose return is lower than the prevailing

accounting return, retaining (depreciated) non-current

assets beyond their optimal useful economic life,

engaging in suboptimal off-balance sheet financing

arrangements such as sale-and-leaseback

transactions, and in the case of ROE undertaking

decretive debt-financed stock repurchases. More

generally, accounting-based return on investment

metrics can create incentives for managers to forego

strategic activities that are value-increasing in the

medium- to long-term in favour of reporting higher

accounting performance in the short-term. 9

5.4 ECONOMIC PROFIT AND VALUE-BASED METRICS

A serious weakness of accounting profit is its failure to

benchmark performance against the cost of invested

capital. As highlighted above, maximising periodic

profit or earnings growth is not necessarily consistent

with value maximisation when capital costs are

omitted. From an economic perspective, value creation

occurs when the return generated by an entity meets

or exceeds the cost of raising funds from external

capital providers. Failure to consider the cost of capital

results in periodic performance measures that do not

properly capture whether management have generated

adequate returns on the recourses at their disposal;

it can also create incentives for management to take

investment decisions that are inconsistent with the net

present value rule.

A series of value-based metrics have been proposed

to overcome this weakness. Such metrics explicitly

acknowledge the costs of both equity and debt

finance and therefore incorporate financing risk-return

trade-offs into the performance measurement problem

(Venanzi 2010). Common value-based performance

measures include Stern Stewart’s Economic Value

Added (EVA©) metric and Boston Consulting Group/

HOLT Value Associates’ Cash Flow Return on Investment

(CFROI) metric. These and related value-based metrics

have their roots in DCF technology and in particular the

need to compare periodic returns against the cost of

capital. Not surprisingly given their common theoretical

base, it can be shown that these metrics yield the

same NPV when consistent assumptions are applied

(Myers 1996).

CFROI compares an entity’s (inflation-adjusted) cash

flow to all capital owners with the (inflation-adjusted)

made by the capital owners to generate those flows.

This ratio of gross cash flows to gross investment

is then translated into an internal rate of return by

recognising the finite economic life of depreciating

assets and the residual value of non-depreciating

assets such as land and working capital.

Stern Stewart’s EVA© represents a special case of

the more general residual income concept (Solomons

1965, Peasnell 1982). Broadly defined, residual income

is equal to periodic return less a charge for the cost of

capital invested in the business. Residual income (RI)

measured from an entity perspective is defined as net

operating profit after tax (NOPAT) minus a charge for all

capital invested in the business:

RI = NOPAT – (WACC * IC),

where NOPAT equals earnings before interest and

taxes (EBIT) plus interest income, minus taxes and

the estimated tax shield on interest payments, WACC

is an estimate of the firm’s weighted average cost

of capital, and IC is invested capital, measured as

assets (net of depreciation) invested in going-concern

operating activities (or equivalently, contributed and

retained debt plus equity capital at the beginning

of the period). 10 Intuitively, RI is an estimate of true

economic profit: the amount by which earnings

exceed or fall short of the required minimum rate of

return that providers of finance could generate by

investing in securities of comparable risk. Positive

RI indicates a return in excess of the cost of capital

used to generate the return (i.e., value creation),

while negative RI indicates that the periodic return is

insufficient to cover the cost of invested funds (i.e.,

value destruction). Theory demonstrates that RI leads

to performance and investment signals that are more

consistent with the NPV rule than periodic profit or

standard return on investment metrics such as ROA

and ROE. Nevertheless, even single-period RI is unable

to guarantee performance and investment signals that

are always fully consistent with the NPV rule (unless

combined with annuity depreciation and constant

annual cash flows) (Otley et al. 1990). 11

Stern Stewart’s EVAÓ metric is an example of how a

measure based on the RI concept can be used as part

of a value-based approach to managing executive

performance. EVAÓ differs from standard RI in equation

(3) as a result of adjustments to published accounting

12 Stern Stewart makes as many as 164 adjustments on residual income to arrive at EVA. See Stewart (1991), Rennie (1997), Young (1999), and Worthington and West (2001) for further details on Stern Stewart’s list of adjustments. Notwithstanding the large number of adjustments that are available, Young and O’Byrne (2001) find it hard to find an EVA© user making more than 15 adjustments. Further, they argue that the number of adjustments employed by firms is declining, and attribute part of the decline to two factors: managers’ reluctance to deviate from GAAP numbers, and the limited impact of adjustments on reported profits. Chen and Dodd (1997: 331) argue that it is possible to gain most of the practical benefits associated with EVA© metric by using the standard residual income metric.

13 In practice, however, use of unfiltered stock price and the resulting excess weighting on market measures may be optimal because it allows shareholders to share part of their trading risks with the manager (Kim and Suh 1993).


numbers made by Stern Stewart that are designed to:

(1) produce a performance measure that is closer to

cash flows, and therefore less subject to the distortions

of accrual accounting; (2) remove the arbitrary

distinction between investments in tangible assets that

are capitalised, and intangible assets that are required

to be written off as incurred; (3) prevent amortisation,

or write-off, of goodwill; (4) bring off-balance sheet debt

(e.g., operating leases) back on the balance sheets; and

(5) correct biases caused by accounting depreciation.12

EVAÓ approaches to performance measurement and

compensation plan design have been adopted by a

significant number of public companies in countries

such as Australia, Brazil, Canada, France, Germany,

Mexico, Turkey, the UK, and the U.S. (Worthington and

West 2001).

Research tests whether residual income and its

cousins such as EVAÓ display higher correlations with

value creation (proxied by share returns) relative to

alternative measures of accounting profit and return.

Results are mixed: while evidence supporting the

incremental value relevance of residual income has

been documented, the magnitude of the improvement

is relatively small and the evidence is not robust

across different samples and time periods (Stewart

1991; O’Byrne 1996, 1999; Biddle et al. 1997; Stark and

Thomas 1998). More direct evidence regarding the

benefits of using residual income-style measures of

periodic performance is reported by Wallace (1996)

using a sample of firms that implement RI-based

reward systems.

5.5 SUMMARY

The primary insight emerging from the review of

accounting-based metrics presented in sections

5.3 and 5.4 is that no practically acceptable profit

performance measure exists that will guarantee

consistency with the results given by DCF techniques

and the NPV rule. Central to this misalignment is the

fact that long-run models of planning and value

creation use cash flows whereas short-term

profit measures are based on accrual accounting

concepts. While accrual accounting provides useful

measures of period performance on average,

over-reliance on these metrics can lead to executives

to make investment decisions that are not in the firm’s

best long-run interests.

6 CHOOSING FROM THE MENU OF AVAILABLE PERFORMANCE MEASURESIn the absence of a first-best measure of periodic

performance, Boards and compensation consultants

are forced to adopt metrics that yield the most

efficient second-best solution to the problem of

measuring and incentivising executive performance.

This section reviews theory and evidence concerning

the choice between alternative performance metrics

for compensation contracting purposes. We begin

by explaining why share price does not represent a

sufficient statistic on which to determine executive

pay. Then we review theory and evidence concerning

the optimal weights assigned to multiple performance

measures used in combination.

6.1 THE ROLE OF SHARE PRICE IN COMPENSATION CONTRACTS

The problem of which performance measure (or set

of measures) to use in the optimal compensation

contract on has been studied widely in principal-agent

literature. Intuitively, one might think that if the

shareholders’ goal is to maximise (long run) firm value

and share price is observable then the solution to

the incentive problem is straightforward: the optimal

contract links managerial compensation to stock price

performance. Casual empiricism, however, reveals that

executive compensation contracts regularly utilise

non-priced-based performance measures, suggesting

that exclusive reliance on market-based measures

(where they exist) does not provide an optimal solution

to the contracting problem. Holmstrom’s (1979) provides

the key insight to help resolve this apparent paradox in

the form of his informativeness principal.

Holmstrom (1979) argues that payments to

managers are based on stock price not because

shareholders desire higher stock prices but because

price realisations provide information useful in

determining which actions management took (given

that managerial actions are not directly observable

by the principal). The insight is profound because it

opens the door to the use of other (non-priced-based)

performance metrics that also provide information on

whether management took the desired action (Banker

and Datar 1989, Feltham and Xie 1994). Holmstrom’s

(1979) formulation therefore provides a clear role for

the use of additional performance measures (such as

accounting-based metrics) in the incentive contract.

Indeed, where these other measures constitute a

sufficient statistic for assessing managerial actions,

share-based measures need not be used at all.

6.2 DETERMINING THE OPTIMAL WEIGHTS FOR CONTRACTS WITH MULTIPLE PERFORMANCE MEASURES

While Holmstrom’s (1979) analysis motivates the

use of performance metrics beyond share price,

it provides few insights into the relative weights

placed on multiple performance measures in the

optimal linear incentive contract. Subsequent

research provides only general guidance on how

individual metrics should be combined to form an

overall assessment of performance. The majority of

theoretical models exploring the relative weighting of

alternative performance measures typically consider

two generic categories of metric: market-based

measures (such as share price and total shareholder

return) and single-period products of the accounting

system (such as net income, operating profit, FCF, and

residual income). Theoretical insights concerning the

way market-based measures and accounting-based

measures are combined to deliver effective contracting

solutions are provided by Banker and Datar (1989),

Bushman and Indjejikian (1993), Kim and Suh (1993),

Lambert (1993), and Sloan (1993) among others. These

models simplify the problem to the choice between

share price and accounting earnings, where the

latter can be any aggregation of periodic income

and expenses.

Research demonstrates that for a contract based on

two performance measures such as stock price (P)

and accounting earnings (E), the incentive weight on

E relative to P is the product of (i) the sensitivity of

each measure to manager’s actions and (ii) precision

of each performance metric. All else equal, the weight

on P (E) in the optimal contract increases both in P’s

(E’s) sensitivity to managerial effort and the precision

with which each measure captures managerial effort

(Banker and Datar 1989, Kim and Suh 1993, Lambert

1993). Performance measures that are insensitive to

managerial effort or that capture effort with significant

measurement error (high noise) will be assigned

low weight in the optimal contract. Nevertheless,

even performance measures that are assigned low

weights are useful under the informativeness principle

because they help to avoid imposing unnecessary

(costly) risk on the executive by filtering noise from

other contracted performance metrics. Motivated by

the prevalent use of accounting numbers in executive

compensation contracts, Sloan (1993) presents

empirical support for the prediction that earnings are

more sensitive to firm-specific changes in value than to

market-wide changes in value and therefore help shield

executives from uncontrollable risks. 13

Insights summarised above apply to a single task

setting (i.e., firm value is a function of managerial

effort choice and the marginal product of managerial

effort). Although informative, this setting is limited

because it is widely acknowledged that in practice

the key contacting problem for senior executives

is not incentivising them to work hard. Instead, the

primary contracting problem typically revolves round

the best way to incentivise managers to allocate

effort appropriately across different tasks (i.e., how

to incentivise managers to choose the correct mix

of actions and decisions that increases shareholder

value). The solution to this problem also highlights the

need for multiple performance measures. In a setting

where fundamental value (V) is unobservable and only

stock price (P) is contractible, theory demonstrates that

a compensation contract relying exclusively on P leads

the executive to misallocate effort between activities

relative to the optimal contracting weights. The solution

to this misallocation problem involves rebalancing

incentives by including additional performance

measures in the contract (Bushman and Indjejikian

1993). All else equal, theory predicts that in such

multi-task settings, the incentive weight on a given

performance measure decreases (relative to the weight

on alternative measures) as the importance to value

of activities not captured by the metric increases. In

particular, Bushman and Indjejikian (1993) demonstrate

14 KPMG (2013) report that 60 (40) percent of new LTIPs introduced by FTSE 350 firms in 2013 used TSR (EPS) either on its own in conjunction with other performance metrics.


that in the case where accounting metrics reflect only

a subset of private information that investors impound

into share price, measures such as earnings serve

to filter uncontrollable factors and achieve a better

balance of incentives across managerial activities.

Feltham and Xie (1994) shed further light on the

properties of performance measures. In addition to

notions of sensitivity and noisiness, they introduce

the idea of congruence, which is best interpreted as a

refined version of sensitivity. While sensitivity focuses

on the association between executives’ actions and

a given performance measure, congruence links a

performance measure directly with the principal’s

payoff. Rather than being evaluated exclusively by its

correlation with executives’ actions, the performance

measure is also assessed according to its alignment

with the principal’s interest. Feltham and Xie (1994)

demonstrate that a contract based on a non-congruent

performance measure induces suboptimal effort

allocation across tasks (effort direction), whereas

performance measure noise results in suboptimal effort

intensity on a given task. Considering the potential

trade-off between congruence and noisiness, the

model demonstrates that multiple performance metrics

should be used jointly to offset limitations associated

with individual metrics.

Building on the notion of congruence, several studies

highlight how performance measures are subject to

distortion (Baker 2000, Bushman et al. 2000, Baker

2002). Distortion occurs when metrics incentivise

managers to take actions that are not congruent

with corporate goals. While distortion and noise are

separate properties in principle, they have similar

effects on performance measure efficacy (Bouwens

and Lent 2006). In particular, both properties are

expected to create weaker incentives resulting in lower

effort levels. Baker (2002) argues that a performance

measure’s usefulness in compensation contract

design depends on its distortion and noise: the more

distorted and the noisier (riskier) the measure, the lower

its usefulness in a compensation contract context.

Furthermore, given the scarcity of performance

measures characterised by low levels of distortion and

noise, contracts typically involve trading off the costs

of high distortion versus high noise.

Inspection of executives’ actual compensation

contracts reveals widespread use of individual

performance objectives such as implementing

restructuring and cost cutting programmes, improving

workforce safety, etc. Bushman et al. (1996) highlight

the use of individual performance evaluation (IPE) in

CEO annual incentive plans and the implication that IPE

is useful in providing incremental information beyond

accounting and market performance measures. Based

on the view that accounting earnings and stock price

collectively may fail to capture information concerning

key executive actions, Bushman et al. (1996) identify

firms where traditional accounting and market metrics

are likely to yield noisy measures of performance, and

test whether IPE is more prevalent in such settings.

Consistent with predictions, results show that

reliance on IPE increases with the length of product

development and product life cycle, level of information

asymmetry between managers and investors, CEO

tenure, and firm size (complexity).

Kaplan and Norton (1992) formalise the idea of

supplementing accounting- and market-based metrics

with qualitative and non-financial performance

measures. They develop a balanced scorecard

approach in which operational measures (e.g.,

customer satisfaction, internal processes, and the

organisation’s ability to learn and improve) are used in

collaboration with traditional financial measures. While

financial measures present information on actions

already taken, operational measures add incremental

information concerning strategy implementation and

activities that drive future performance. Ittner et al.

(1997) examine the factors associated non-financial

measure usage and find that firms following an

innovation-oriented “prospector” strategy are more

likely than firms following a cost leader or “defender”

strategy to place greater weight on non-financial

metrics. Firms following quality-oriented strategies also

place more weight on non-financial measures.

7 EVIDENCE ON PERFORMANCE MEASURE SELECTIONThis section reviews evidence from the academic and

professional literatures on the choice of performance

measures in executive compensation contracts.

Early research on this topic was limited by a lack of

transparency. However, improvements in disclosure

requirements mean that clearer insights regarding

the performance metrics that drive executive pay are

now possible.

Consistent with predictions from agency theory,

UK-listed firms pre-specify executive goals over

multiple performance metrics (Conyon et al. 2000,

Pass et al. 2000, Young and Yang 2011, PwC 2012, KPMG

2013). From the menu of available performance metrics,

research reveals that income measures (e.g., EPS, net

income growth, and EBIT), accounting returns (e.g.,

ROE and ROA) and market-based metrics such as TSR

dominate. For example, KPMG (2013) report that 60 (57)

percent of FTSE 350 companies’ performance share

plans use TSR (EPS) either separately or in conjunction

with other measures. Meanwhile, the most common

combination of performance measures for FTSE 350

CEOs consists of either a two-way mix of financial

and personal metrics or a three-way combination of

financial, non-financial, and personal metrics, with FTSE

100 (250) firms preferring the three-way (two-way) mix

(PwC 2012).

Studies reveal that performance measure choice

varies significantly across individual compensation

components. For annual bonus plans and

performance-vesting share options, income measures

tend to dominate (Young and Yang 2011, PwC 2012).

Profitability measures such as operating profit, profit

before tax, earnings before interest and tax (EBIT)

are used by approximately 50 percent of firms for

determining bonus payments, with EPS the next most

popular metric (26 percent) (Young and Yang 2011).

Other accounting metrics such as return on capital and

residual income are used by fewer than five percent of

firms. Meanwhile, EPS is used in the majority of firms’

performance-vesting option plans.

While TSR is rarely used in annual cash-based bonus

plans and performance-vesting share options, it is the

most widely used measure in LTIPs: 18 (20) percent

of FTSE 100 (250) firms use it in isolation, 27 (38)

percent in conjunction with EPS, and 28 (10) percent in

conjunction with other metrics (PwC 2012). 14 TSR is also

used as frequently as EPS in share matching deferred

annual bonus plans (either on its own or in conjunction

with other metrics).

Non-financial metrics (e.g., customer satisfaction,

market share, employee safety, sustainability

targets, etc.) and personal objectives are also used

to determine executive pay. While traditionally these

metrics were limited largely to bonus plans (Young

and Yang 2011), recent survey results suggest their

popularity is growing in LTIPs. (See section 9 for further

discussion.)

Similar patterns to those documented above for

UK-listed firms are also evident among their U.S.

counterparts. De Angelis and Grinstein (2014) find that

of the total estimated value of performance-based

awards for the average S&P 500 firm, 79 percent is

based on accounting-performance measures, 13

percent is based on share-based measures, and 8

percent is based on non-financial measures. Also

consistent with UK results, De Angelis and Grinstein

(2014) report that 56 percent of the estimated value

of accounting-based performance awards are linked

with income measures such as EPS, 17 percent with

accounting return measures, and 12 percent with

sales measures. Evidence from academic studies is

consistent with survey evidence that also highlights

the dominance of EPS and TSR (e.g., PwC 2009, Towers

Watson 2013).

Commonly used measures of performance such as

EPS and TSR do not ensure perfect alignment with

long-term value maximisation. Investment decisions

taken by executives with the aim of achieving (EPS

and or TSR) performance targets need not lead to

corresponding improvements in firm value; because

maximizing these metrics can be done in

undesirable ways.

Indeed, motivating executives to turn in good measures

of performance can cause more problems than it

solves. The primary incentivisation problem is not about

encouraging executives to achieve specified results:

it is more about ensuring results are achieved in the

appropriate manner. The following section discusses

the negative consequences of performance-related

compensation arrangements.

8 THE UNINTENDED CONSEQUENCES OF PERFORMANCE-RELATED COMPENSATION This section examines the problems of linking

executive pay to imperfect measures of corporate

performance. We begin by highlighting the behavioural

consequences associated with measuring and

rewarding performance. Evidence on a range of

15 For models of performance manipulation, see Bolton et al. (2006), Goldman and Slezak (2006), and Benmelech et al. (2010).:

16 Such claims reward executives for share-price appreciation above the exercise price but do not penalize them when share price falls below the exercise price. Accordingly, executives with options close to expiration and that are out of the money have strong incentives to gamble. Annual bonus plans have similar characteristics. Bonus payments are a linear function of performance above the minimum performance threshold required to trigger payouts but executives do not face “negative bonuses” as performance declines below the threshold level. As a result, executives just below the threshold level face particularly powerful gaming and risk taking incentives.


unintended consequences are reviewed including

short-termism, manipulation, excessive risk taking,

and threats to corporate culture. We conclude with a

brief summary of the debate surrounding the role that

executive compensation arrangements played in the

recent global financial crisis.

8.1. WHAT YOU PAY IS WHAT YOU GET

A large body of research in the psychology and

management literatures clearly demonstrates that

the existence of a particular performance measure

together with appropriate rewards will motivate

actions that improve the measure. Of course, this is

precisely the reason why performance management

systems play such an important role in overcoming

agency problems. Wallace (1996) highlights the

positive aspects of this effect in the context of residual

income-based compensation plans that create

incentives to increase operating efficiency, asset

utilisation, and payouts of excess cash to shareholders.

However, the powerful behavioural effects that

performance-related pay can have on individuals’

actions is a double-edged sword insofar as it can lead

to fixation on achieving narrowly-defined performance

outcomes that are at odds with long-term value

creation. The organisation and management literatures

are littered with examples of what Kerr (1975) refers

to as the folly of rewarding A but hoping for B. The

message from a vast body of literature in economics,

management, strategy, organisations, finance, and

accounting is unambiguous: what you pay is what

you get. Considerable care is therefore required to

ensure performance metrics incentivise appropriate

value-increasing behaviour rather than promoting

dysfunctional, value-decreasing actions. Examples of

dysfunctional behaviour leading to value-destroying

decisions caused by performance metrics that do not

align perfectly with long-run organisational objectives

include investment myopia, earnings manipulation and

gaming, excessive risk taking, and threats to corporate

culture and reputation. Choosing a performance metric

(or set of metrics) that incentivises preferred outcomes

and minimises the risk of dysfunctional behaviour

is critical to the effectiveness of reward systems in

general and executive compensation arrangements in

particular (because executives control more financial

resources and therefore face greater opportunities to

damage value through poorly aligned decisions).

8.2 INVESTMENT MYOPIA

Stein (1989) shows analytically how managerial

myopia can exist as an equilibrium outcome even

when capital markets are efficient. Short-termism is

widely acknowledged as representing a significant

threat to overall UK competitiveness (Marsh 1990,

CFA Institute 2006, Kay Review 2012, CFA UK 2011a).

Research supports claims of myopic corporate

decision-making generally and highlights the role that

compensation-related incentives play in encouraging

managerial short-termism. Graham et al. (2005)

survey 400 senior U.S. financial executives and find

that 80 percent of respondents acknowledge they

would decrease value-creating spending on research

and development (R&D), advertising, maintenance

and hiring to report positive short-term earnings

growth. Consistent such claims, archival research

demonstrates that management are more likely to

reduce discretionary investment expenditure when

doing so helps their firm achieve quarterly or annual

earnings expectations (Bushee 1998, Osma-Garcia and

Young 2009).

Research examining the impact of compensation

plan design on investment decision-making highlights

the importance of performance metric choice. On

the positive side, Wallace (1996) demonstrates how

adoption of residual income-based bonus plans

designed to motivate long term value creation leads

executives to dispose of underperforming assets that

had been generating positive earnings but not covering

the cost of capital. In contrast, Dechow and Sloan

(1991) study investment decisions by CEOs in the years

immediately prior to retirement and find that retirees

cut spending on R&D in their last years of office in an

effort to maximise short-run compensation linked to

earnings performance. Recent research examining

the causes of the financial crisis also suggests a link

between CEO compensation arrangements and myopic

decision making (Cai et al. 2010, Erkens et al. 2012). (See

section 8.5 for a more complete summary of the role of

executive compensation in financial crisis.)

8.3 GAMING

Murphy (2012) concludes that any form of incentive

compensation introduces the risk that managers will

opportunistically manipulate performance outcomes

to achieve favourable compensation payouts. 15

Manipulation may take the form of accounting trickery

(earnings management) or suboptimal decision-making

with respect to operating activities and investments

(real earnings management). Empirical evidence

supports the view that managers use their accounting

and investment discretion to deliver performance

outcomes that maximise short-term compensation

payouts (Healy 1985, Dechow and Sloan 1991,

Bergstresser and Philippon 2006, Burns and Kedia

2006, Johnson et al. 2009). The evidence confirms the

prediction from behavioural psychology that individuals

focus effort on actions that ensure favourable

outcomes in relation to the measure(s) against which

their performance is assessed: what you pay is what

you get.

Non-linearities in bonus plan structures such as caps

and floors represent a particularly egregious source

of manipulative behaviour (Healy 1985, Holthausen

et al. 1995, Jensen 2003). Long-term compensation

awards are granted to mitigate manipulation problems

associated with bonus plans and short-term

performance measures. However, equity incentives

also create incentives for gaming aimed at boosting the

value of share-based rewards either by manipulating

earnings (Bergstresser and Philippon 2006, Burns

and Kedia 2006, Gao and Shrieves 2002, Cheng and

Warfield 2005, Efendi et al. 2007, Peng and Röell 2008,

Johnson et al. 2009) or by manipulating the grant date

timing of options (Yermack 1997, Aboody and Kasznik

2000, Heron and Lie 2009, Bebchuk et al. 2010). In

contrast, Armstrong et al. (2010) report that CEOs with

large stock option and equity holdings are less likely to

manipulate published accounting results, consistent

with the view that equity incentives help to reduce

agency problems.

Executives may also manipulate other aspects

of their compensation arrangements including

performance standards, risk, peer groups, and

disclosures. For example, executives may seek to

avoid target ratcheting (Holthausen et al. 1995) by

reining-in reported results in an attempt to prevent

high contemporaneous performance establishing

a benchmark against which future performance is

assessed. Meanwhile, Faulkender and Yang (2010)

argue executives have multiple ways to hedge against

the risks of exposure in high-powered contracts and

it is hard to tell whether managers do it to efficiently

rebalance their portfolios when firm-specific holdings

are excessive or just to remove appropriate incentives.

Core et al. (2003) report that derivatives are often used

to hedge firm-specific risk by managers.

Where executive compensation contracts contain a

significant RPE component, management can affect

payouts by exercising their discretion over the choice

of peer group constituents. All else equal, selecting peer

groups characterised by weaker performance will lead

to higher payouts under RPE. Carter et al. (2009) use UK

data and find limited evidence supporting opportunism

with respect to peer selection. Peer groups are also

relevant in terms of compensation benchmarking,

creating incentives to opportunistically select firms

where CEOs are highly paid (Faulkender and Yang 2010,

Bizjak et al. 2011). Albuquerque et al. (2013) on the other

hand argue that choice of highly paid peers represents

a reward for unobservable CEO talent.

8.4 EXCESSIVE RISK TAKING

There are two ways incentive compensation can create

incentives for risk taking. The first way is through

asymmetries in rewards for good performance and

penalties for failure (Conyon et al. 2013). Linear payout

structures ensure that executive wealth increases

and decreases symmetrically with changes in firm

value. Most pay-performance structures, however,

involve significant non-linearities such as convexity

in the share option payout function: executives

receive rewards for upside risk but are shielded from

the negative consequences of downside risk. 16 A

consequence of such arrangements is that executives

can face strong incentives to take excessive risks with

shareholders’ capital when their compensation payoffs

are out of the money. Essentially, management face

a “double or quits” gamble where they benefit from

upside gains and are insulated from downside losses.

Linearizing the payout function provides an obvious

solution to the problem of excessive risk taking

because executives take less risk when they face

symmetric consequences. However, several factors

mitigate against such a solution. First, managerial


risk aversion (or at least lower risk tolerance relative

to shareholders) provides a partial explanation for

convex payout structures. Second, negative bonuses

(or claw-backs) can be difficult to implement in

practice, especially if executives have paid tax

on any payouts. One solution is deferred payouts

that are subject to partial forfeiture if performance

subsequently deteriorates.

The second route by which incentive compensation

creates incentives for excessive risk taking is when

payouts are tied to performance metrics that either

implicitly or explicitly reward risky behavior. A clear

demonstration of this effect was evident in the run-up

to the recent global financial crisis, where incentive

systems operated by financial institutions that

rewarded individuals on the basis of the quantity of

lending decisions made rather than on the quality of

those decisions, as reflected in borrowers’ ability to

repay (Conyon et al. 2013). (See section 8.5 below for

a broader discussion of the links between executive

compensation and the financial crisis.)

8.5 THREATS TO CORPORATE CULTURE

In addition to the problems of investment myopia

and earnings management, Jensen (2003: 380)

highlights the broader organisational consequences

of using inappropriate performance metrics that “…

reward people for lying … and punish them for telling

the truth.” Jensen (2003) argues that such systems

and the gaming behaviour they engender threaten

corporate value in several ways. First, gaming strips

the accounting system of critical unbiased information

required to coordinate disparate elements of the

organisation. Second, gaming behaviour by senior

executive sets the tone for all other parts of the

organisation and even its relationship with outside

stakeholders.

8.6 EXECUTIVE COMPENSATION AND THE FINANCIAL CRISIS

The recent global financial crisis raised concerns

about the role of compensation arrangements in the

financial services sector and in particular whether the

structure of executive compensation contracts created

incentives for excessive risk taking. For example,

former Financial Services Authority chairman Adair

Turner observed that “there is widespread concern

that inappropriate (bankers’) remuneration schemes

contributed to the market crisis’ (cited in Farmer et al.

2013). The chain of logic linking bankers’ compensation

and the financial crisis typically involves the following

steps: the financial meltdown involved banks; banks

rely heavily on bonuses; and pay levels in banks are

very high (Conyon et al. 2013).

Empirical tests examining the relationship between

bank executive compensation and the financial crisis

provide mixed evidence. Fahlenbrach and Stulz (2011)

investigate 95 U.S. banks from 2006 to 2008 and

find that CEOs with better incentives (more equity

incentives) faced strong motives to take appropriate

risks, since their firms performed worse during the

crisis. Similarly, Cheng et al. (2010) find evidence that

executives whose incentives were better aligned with

those of shareholders were associated with superior

performance before the crisis but suffered larger

losses during the crisis. Focusing on the UK, Gregg et al.

(2012) find no evidence that the cash pay-performance

sensitivity for financial firms was significantly higher

than in other sectors, leading them to conclude that

incentive structures are unlikely to have induced

bank executives to focus excessively on short-term

results. Meanwhile, Murphy (2009) shows that average

executive bonuses at banks participating in the

Troubled Asset Relief Program (TARP) decreased by

84 percent compared with a decline of 20 percent for

non-TARP banks. One interpretation of these

findings is that bank executives faced strong

incentives to avoid risk taking. Theory also suggests

that if bank executives had advance knowledge

about the crisis they would have engaged actions to

hedge their risk. However, neither Fahlenbrach and

Stulz (2011) nor Murphy (2009) find evidence supporting

such behaviour.

Other work provides some support for a link between

pay structures and excessive risk-taking in the banking

sector. For example, Erkens et al. (2012) study losses

at 206 banks in 31 countries and conclude that both

ex ante risk taking and ex post losses are greater

when CEOs receive higher cash bonus compensation.

Bebchuk and Spamann (2010) argue that the capital

structure at financial institutions led to risk-oriented

behaviour by CEOs before the crisis aimed at boosting

stock prices. In related work, Cai et al. (2010) argue that

compensation contracts are designed to maximise

shareholders’ wealth instead of debtholders’ wealth.

Since banks are characterised by higher debt levels

and greater financial leverage, traditional compensation

contracts create a bias toward excessive risk taking in

the banking sector. Results reported by Cai et al. (2010)

are consistent with Conyon et al.’s (2013) argument

that choice of inappropriate performance measures,

rather than pay levels or the link between pay and

performance per se, was a primary driver of poor

decision making among financial institutions.

9 THE PARADOX OF EXECUTIVE COMPENSATION PLAN DESIGN Evidence presented in the previous section suggests

that the weaknesses of commonly employed

metrics linking executive pay with firm performance

are numerous, economically significant, and well

documented. Given widespread public outrage over

executive pay arrangements in general and the

potential disconnect between pay and value creation

in particular, coupled with extensive theoretical

and empirical evidence regarding the limitations of

traditional accounting- and market-based measures

of performance, it is surprising that prevailing

compensation structures appear so resilient. This

section considers how such an outcome can persist

as a stable equilibrium when the weaknesses appear

so clear.

Several (non-mutually exclusive) reasons may account

for the persistence of apparently flawed executive

compensation arrangements. Perhaps the simplest

explanation reflects the second-best nature of

compensation contracting and periodic performance

measurement. In the absence of first-best solution,

firms settle on second-best arrangements in which

the alignment benefits of prevailing compensation

arrangements outweigh the costs described above.

These costs represent part of the residual agency

costs of economic organisation that contracting

parties deem too costly to eradicate. Under this

view, corporate boards, regulators, and other

governance mechanisms seek to minimise agency

compensation-related costs up to the point where

the marginal cost of further reductions outweigh the

marginal gains to capital providers.

Efficient contracting offers a related explanation for

the prevailing compensation equilibrium. Although

current arrangements may appear inefficient and

prone to unintended consequences, it is possible that

apparent weaknesses mask important benefits. Take

for example the ubiquitous use of EPS performance

conditions. It is widely accepted that EPS targets

correlate poorly with long-term value creation and

encourage overinvestment (Brealey et al. 2008,

889); and yet this performance criterion remains in

widespread use. Research suggests that EPS-based

compensation plans can provide a simple, low cost

means of addressing agency conflicts between

managers and shareholders by incentivising managers

to take decisions that promote shareholder value. For

example, EPS performance conditions help mitigate

ownership dilution (Huang et al. 2010). Similarly,

because per share-based targets create incentives

for management to manipulate reported performance

by repurchasing stock, EPS-based compensation

can motivate executives to distribute surplus cash,

increase leverage, and correct underpricing in a timely

manner (Young and Yang 2011). Such “hidden” benefits

may help to explain why EPS-based targets remain a

popular choice in executive compensation contracts

despite their obvious limitations. Similarly, Wiseman

and Gomez-Mejia (1998) demonstrate how simple

external metrics such as share price can help promote

better risk alignment by encouraging executives to take

more risk.

A third explanation for the persistence of seemingly

flawed compensation structures draws on the theory

of limits to arbitrage (Shleifer and Vishny 1997, Gromb

and Vayanos 2010). In an efficient market, failure to

link executive pay to long-term value creation and the

likely dysfunctional outcomes resulting from the use of

naïve or inappropriate performance measures should

result in predictable value losses and hence arbitrage

opportunities. The absence of any robust evidence that

firms with poorly designed executive compensation

arrangements trade at a material discount suggests

that investors may face limits of arbitrage. For

example, fund managers subject to short-term (e.g.,

quarterly) performance appraisal horizons may face

weak incentives to trade when compensation-related

valuation consequences only materialise in the

medium- to long-term (i.e., mispricing exists over an

extended period).

Managerial power theory provides another

explanation for the resilience of prevailing executive

compensation arrangements. Motivated by high

compensation levels and evidence of weak linkages

with performance, managerial power theory

presents executive compensation as a suboptimal


arrangement where senior executives extract

economic rents from shareholders (Bebchuk and Fried

2004, 2006). The theory has its roots in traditional

principal-agent models but includes the additional

insight that executives can influence both the level and

composition of their own pay packages. Managerial

power theory argues that compensation contracts

are not the outcome of arm’s-length contracting. A

primary implication of this view is that rather than

representing a solution to the corporate governance

problem, executive compensation is part of the agency

problem. In particular, Bebchuk and Fried (2004,

2006) argue that the both the level and composition

of pay are determined by captive board members

catering to rent-seeking entrenched executives.

Accordingly, executives are characterised as setting

pay in their own interests rather than in the interest of

shareholders, and as a consequence executive pay

is excessive. Nevertheless, the degree of managerial

power is limited by outrage constraints (e.g., financial

media backlashes and the risk of political intervention)

and therefore executives extract rents through

difficult-to-observe or assess forms of compensation.

Evidence supporting the managerial power perspective

is mixed. Consistent with the managerial power

hypothesis, Morse et al. (2011) predict that powerful U.S.

CEOs rig incentive pay by inducing boards to shift the

weight on performance measures toward those that

present the most favourable view of firm performance.

Results suggest find that rigging accounts for at least

10% of the pay-performance sensitivity and is positively

correlated with CEO human capital and firm volatility.

In contrast, De Angelis and Grinstein (2014) examine

cross-sectional variation in performance measures and

conclude that metric selection is more consistent with

predictions from optimal contracting theories insofar

as firms appear to rely on performance measures that

are informative of executives’ actions. In particular, their

findings provide no support for Bebchuk and Fried’s

(2003) managerial power hypothesis that entrenched

CEOs rig the contractual terms toward performance

measures that are easier to manipulate.

10 REVIEW AND DISCUSSION10.1 FOCUSING ON VALUE CREATION

A stand-out feature of the collective empircial evidence

on performance measure selection reviewed in section

7 is the lack of clear links between compensation

outcomes and measures of fundamental value creation

that capture firms’ strategic priorties and the extent

to which these priorities are being implemented

effectively. Further, the most commonly used metrics

are associated with dysfunctional, value-reducing

activities as reviewed in section 8. Two features

of current practice are particularly striking: (i) the

dominance of equity-level performance measures and

corresponding infrequent use of entity-level metrics

such as free cash flow and NOPAT that capture returns

to all claimholders, and (ii) the derth of metrics such as

residual income and economic profit that benchmark

periodic performance against the cost of capital.

Although consistent with traditional principal-agent

models, the dominance of equity-based metrics such

as EPS and TSR contrasts with the main source of

financing for UK business. CFA UK (2011a) conclude

that less than one percent of UK business entities

meeting the legal definition of a company are publicly

listed and that as a result most companies rely on

non-equity sources of capital (in particular debt) to

achieve their long-term objectives. Insofar as most

UK companies, even those with significant equity

listings, rely on finance from non-equity sources, the

issue of measuring periodic performance and value

creation shifts from a narrow emphasis on shareholder

returns to a broader focus on value generation for all

claimholders. It is within this context that CFA UK (2011a)

criticised the Kay Review for adopting an excessively

narrow focus on the UK equity market and shareholder

returns at the expense of other asset classes.

The low incidents of performance measures that

benchmark returns against the cost of capital is

also a potential cause for concern. CFA UK (2011a)

surveyed members’ views on executive compensation

arrangements in response to the Kay Review (2012).

Results revealed serious disquiet with respect to

prevailing executive compensation arrangements.

From the 267 responses received from analysts and

investors:

» 63 percent felt that boards and senior executives

paid too much attention to short term share price

movements;

» 86 percent agreed or strongly agreed that boards

and senior executives of UK listed companies should

focus on economic profits ahead of accounting

profits;

» 88 percent agreed or strongly agreed that to

generate economic value a publicly listed company

should at least cover its weighted cost of capital

(equity and non-equity);

These responses in turn led CFA UK to express doubts

over the proportion of senior UK executives that are

actually aware of their firm’s cost of capital, and

the fraction that know the extent to which their firm

generates returns in excess of its cost of capital.

Collectively, the evidence presented above supports

concerns expressed by a range of corporate

stakeholders that UK corporate managers and Boards

focus on accounting profit and (short-term) share price

performance rather than generating economic profits,

with the consequence that the link between executive

remuneration and models of economic value creation

tends to be weak (CFA UK 2011a and 2011b, Kay Review

2012, Towers Watson 2013). These views are consistent

with responses to a UK Government consultation

on long-term decision making and value creation,

which concluded that the tendency for companies

to rely on TSR and EPS as performance measures is

unhelpful (DBIS 2011). The High Pay Commission has

also expressed concern that prevailing compensation

arrangements reward executives for short-term

behaviour aimed at driving up share price; and that

this horizon problem is further compounded by

evidence that CEO tenure has shrunk to four years.

As a consequence, management face short-term

decision-making pressure aimed at boosting EPS

rather than improving productivity and investing in the

long-term future of the company (High Pay Commission

2014). Smithers (2014) argues that declining investment

rates and increasing profit margins is evidence

consistent with short-term pressure on executives

resulting in part from the way CEOs are incentivised

and rewarded. Finally, while Towers Watson (2013)

acknowledge the benefits associated with the general

increase in emphasis on pay for performance, they

also highlight the dangers of over-reliance on narrow,

simplistic measures of performance such as TSR

and EPS to the detriment of measures capturing

sustainable performance and fundamental value

creation. As Towers Watson (2013) stress, an important

distinction exists between paying for performance and

compensating management for strategic success.

CFA UK (2006) emphasised the importance of

focusing on long-term value creation. Amongst

their recommendations was that compensation for

corporate executives should be structured to achieve

long-term strategic and value-creation goals rather

than short-term targets based on accounting numbers

or share price movements. The Kay Review (2012)

also stressed the need for more focus on long-term

performance, albeit with an exclusive focus on equity

investors. The focus on long-term value creation

is a theme echoed by the National As-sociation of

Pension Funds (NAPF) in their most recent guidance on

executive compensation (NAPF 2013) and by The Aspen

Institute (2010). Specifically, NAPF (2013) highlight both

the unintended consequences of aligning executive

compensation with shareholder returns in the form

of overly aggressive payout policies and investment

strategies focused on short-term equity returns, and

the importance of linking rewards with performance

measures that directly reflect strategic objectives and

capture long term value creation. Similarly, The Aspen

Institute (2010) stress the need for management and

boards to recognise the existence of multiple types of

capital provider, balance these interests for long-term

success, and de-emphasise short-term financial

metrics such as quarterly EPS in favour of metrics that

reflect entities’ long-term strategic goals.

Concern over the way corporate performance is

measured for executive compensation purposes

expressed by The Kay Review, CFA UK, NAPF, DBIS,

and the High Pay Commission reflects something

of a disconnect with evidence on shareholder

voting behaviour in response to recent say on pay

developments. Following the introduction in 2002

of the advisory shareholder vote on the directors’

remuneration report in the UK, the average level of

dissent against remuneration reports in FTSE 350

companies oscillated between three and six percent

prior to the financial crisis. The onset of the financial

crisis predictably saw share-holder activism increase,

with 20 percent of shareholders of FTSE 100 companies

withholding support for the remuneration report in

2009 (DBIS 2011). Nevertheless, the level of dissent

remains surprisingly low given widespread concern

about executive pay. Further, although research

demonstrates that dissent is partly motivated by

perceptions of weak pay-performance sensitivity (Ferri

and Maber 2010; Carter and Zamora 2009), calls for

remedial action tend to focus more on strengthening

explicit links with conventional metrics such as EPS

and TSR rather than on the more nuanced issue of

17 For example, recent guidelines from the ABI recommends just three elements: fixed pay, bonus, and one LTIP. Some are going further and proposing a radical simplification of the LTIP itself. One approach that has received a lot of attention is HSBC’s “performance on grant model”. Here the conventional LTIP is replaced by an award of shares made according to pre-grant criteria, with a longer than usual vesting period (five years) during which shares are subject to claw-back, and executives are subject to an extended shareholding requirement (KPMG 2013). The idea of career shares is also been proposed by Main et al. (2011) and discussed by DBIS (2011: 35).


which specific measure(s) of performance to use. In

particular, published research provides no evidence

that shareholder concern about a lack of alignment

between performance metrics and corporate strategy

is a significant driver of dissent over compensation

arrangements. Instead, debate often appears to fixate on

the quantum of pay. Of even greater concern is Towers

Watson’s (2013) evidence of a significant unintended

consequence of recent U.S. say on pay reforms in

the form of greater conformity in compensation plan

design (and in particular a shift toward more long-term

incentives linked directly to TSR).

Shareholders’ apparent indifference to prevailing

performance measures may be partially explained by

perceived alignment between shareholders’ interests

and commonly used metrics such as EPS and TSR. As

CFA UK (2011a) and Towers Watson (2013) acknowledge,

however, the distinction should be made between value

generation and return generation. While the former is

consistent with a value-based management approach

that stresses returns to all claimants in excess of the

cost capital, the latter typically involves returns to

shareholders resulting from share price movements

over an investor’s preferred investment horizon. In

addition to value creation, return generation also

recognises and exploits the fact that share prices may

deviate from fundamentals for a variety of economic

and behavioural reasons. As the academic literature

and policy debate on investment myopia clearly

demonstrates, measures of return generation such as

EPS growth and TSR do not necessarily align perfectly

with long-term value creation.

10.2 EMERGING TRENDS

Notwithstanding evidence of low shareholder

engagement with the issue of performance metric

selection via the say-on-pay initiative, UK companies

are facing increased pressure to demonstrate how the

measures linking executive compensation with firm

performance align with business strategy. PwC (2012)

note the increasing trend toward the use of bonus plan

performance metrics that are more aligned to business

performance indicators: the vast majority of FTSE 350

firms use a combination of financial, non-financial and

personal targets, with non-financial (financial) being

more common among FTSE-250 (FTSE-100) firms. A

similar trend is also evident with respect to long-term

incentive arrangements. For example, although TSR

and EPS continue to dominate in share incentive plans,

FTSE 100 firms are increasingly using these metrics in

conjunction with other measures which may be more

aligned to a company’s strategic objectives (PwC

2012, KPMG 2013). There is also evidence that FTSE

100 companies are starting to combine traditional

metrics such as TSR and EPS with alternative

performance metrics such as cash flow and return on

invested capital (Deloitte 2010). Accordingly, CEO pay

in large firms appears to be increasingly contingent

on a balanced set of performance metrics (beyond

traditional accounting- and market-based metrics) that

designed to link more closely with companies’ strategic

priorities and business model (Kaplan and Norton 1992).

Nevertheless, benchmarking periodic returns against

the entity’s cost of capital remains the exception rather

than the norm.

Expanding the set of performance metrics to deliver

better strategic alignment involves trading-off the

benefits of improved line of sight with value creation

against the costs of greater complexity. Research

suggests that executives tend to discount the

value of remuneration subject to complex long-term

performance criteria, particularly if they feel they have

little control over those criteria (Towers Watson 2011).

This in turn may drive increases in overall remuneration

because executives expect higher pay in reward for

higher risk (DBIS 2011). Complexity also risks obscuring

shareholders’ line of sight between the levels and

structure of remuneration and executives’ performance

in meeting their company‘s strategic objectives

(DBIS 2011, PwC 2010). It has also been suggested

that complex schemes increase the likelihood that at

least some elements will pay out, leading to higher

overall pay awards. These concerns have led some

stakeholders to suggest that the challenges associated

with establishing the right mix of performance

measures, together with lack of convincing evidence

demonstrating that more complex remuneration

structures help improve decision making and drive

company performance, points to the need for a radical

simplification of executive remuneration arrangements

(PwC 2011). 17

11 SUMMARY AND CONCLUSIONSKey insights emerging from our review of the academic

and professional literatures on executive compensation

and corporate value creation are as follows:

» Economic theory provides guidance on

compensation plan design and the importance of

linking rewards to observable outcomes. However,

while theory dictates that investment decisions

should be made on the basis of discounted cash

flows and the net present value rule, periodic

performance measurement poses challenges

for which economic theory provides only limited

guidance. As a result, theory offers little direct

help with the practicalities of measuring economic

outcomes against which managerial performance

should be judged and rewarded.

» An effective performance measure should capture

whether executives have generated adequate

returns on the resources at their disposal, while also

ensuring management make appropriate investment

decisions (i.e., invest in additional resources only

when such investments produce an adequate return

and divest existing assets that are not yielding an

adequate return). Firms create value when they

generate economic profits, defined as returns that

meet or exceed the entity’s cost of capital. Economic

profits differ from accounting profits and share

returns because the latter metrics do not include

a periodic charge for the cost of invested capital.

Failure to benchmark periodic performance against

the opportunity cost of funds can lead to misleading

signals regarding the degree of value creation during

the measurement period.

» In the absence of a first-best measure of periodic

performance, corporate boards and compensation

consultants employ metrics that yield the most

efficient second-best solution to the problem of

measuring and incentivising executive performance.

» Empirical evidence highlights two striking features of

current practice. First, the dominance of equity-level

performance measures and corresponding

infrequent use of entity-level metrics such as free

cash flow (FCF) and net operating profit after tax

(NOPAT) that capture returns to all claimholders.

Second, the derth of metrics such as residual income

(RI) that benchmark periodic performance against

the cost of capital.

» Contrary to insights from the value-based

management literature, mainstream research and

practice focuses on simplistic measures of periodic

performance such as earnings per share (EPS)

and total shareholder return (TSR) that (i) focus

exclusively on returns to shareholders and (ii) ignore

the cost of capital.

» Prevailing practice supports concerns expressed by

a range of corporate stakeholders that UK corporate

managers and boards place excessive emphasis

on accounting profit and (short-term) share price

performance, with a consequence that the link

between executive pay and models of economic

value creation tends to be weak. There exists a

danger that corporate boards may be failing to

recognise the crucial distinction between paying for

performance and compensating management for

strategic success.

» The unintended consequences of over-reliance on

narrow, simplistic performance metrics that align

poorly with value creation are well documented

in the academic literature. The negative effects

of using inappropriate performance metrics to

evaluate, incentivise and reward executives include

investment myopia, earnings manipulation, excessive

risk taking, and threats to organisational culture.

» The majority of investor and media debate

surrounding the link between executive pay and

corporate performance continues to focus primarily

on strengthening explicit links with conventional

performance metrics such as EPS and TSR rather

than on the more important issue of selecting the

most appropriate measure(s) of performance to

use. An increasing trend toward using performance

metrics more closely aligned to key performance

indicators and long-term value creation is

nevertheless apparent, although bench-marking

periodic returns against the entity’s cost of capital

remains the exception rather than the norm.

18 Our empirical tests do not adjust for CEO turnover during the sample window. Failure to adjust for turnover is expected to introduce noise into our analyses leading to a downward-biased estimate of the association between CEO pay and firm performance.


PART 2:

EMPIRICAL ANALYSISThis component of the report presents empirical evidence on executive compensation plan design and links with value creation for a representative sample of FTSE-100 companies, with complete data for the period 2003 to 2013. The research is structured according to the following eight sections. The next section outlines the aims and scope of the analysis. Section 13 provides details of our research design, including definition and measurement of key performance-related variables - such as cost of capital, free cash flow, residual income, TSR and EPS growth - as well as details of the methods used to compute the equity-based component of executive compensation. Section 14 reviews our sampling procedure and reports summary statistics relating to compensation plan design and our annual performance metrics. Sections 15 to 18 present our empirical findings and section 19 concludes.

12 AIMS AND SCOPE The empirical analysis seeks evidence on the following questions using data for a sample of large companies listed on the London Stock Exchange:

1 What is the degree of alignment between alternative measures of periodic performance?

The review presented in Part 1 highlights a range of alternative approaches to measuring periodic performance and value creation, and the potential drawbacks associated with various approaches. Given the importance for compensation plan design of selecting performance metric(s) that encourage and reward appropriate investment and operating behaviour, evidence is required on the degree to which alternative metrics provide similar or conflicting signals with respect to periodic performance and value creation. We compare the degree of alignment (correlation) between the performance signals provided by the following group of metrics: total shareholder return (TSR), free cash flow to the firm (FCF), residual income to the firm (RI), cash flow return on investment (CFROI), return on assets (ROA), return on equity (ROE), and earnings per share (EPS) growth.

2 To what extent is executive compensation aligned with various measures of periodic performance, with particular emphasis on the extent of correlation

between compensation and value creation?

Effective executive compensation arrangements

are those that incentivise and reward behaviour that

generates value for the providers of capital to the

business. An important empirical question concerning

executive compensation arrangements in the UK

concerns the degree to which remuneration outcomes

are linked to value creation. We seek evidence on the

aspects of company performance that correlate with

executive remuneration outcomes, and the extent to

which compensation realisations are linked to periodic

value creation metrics versus alternative performance

measures whose association with value generation is

less obvious.

3 How do the performance metrics employed in

executive compensation plans align with the key

performance indicators that drive value at the individual

company level?

Effective strategy implementation involves measuring

and managing the core metric(s) that influence how

value within a business is created. Companies are

increasingly disclosing information on the critical

success factors or key performance indicators (KPIs)

that are predicted to drive organisational success.

An important empirical question concerns the degree

of alignment between remuneration arrangements

designed to incentivise and reward executive

performance and these core drivers of business

success. Accordingly, we seek evidence on the extent

to which firm-specific KPIs are reflected in executive

compensation arrangements.

Empirical tests focus on CEO compensation

arrangements for several reasons. First, as the most

senior executive in the company, compensation

arrangements for the CEO attract the most attention

from external parties and arguably have the largest

potential impact on organisational performance

and strategic direction. Second, CEO pay structures

are a good proxy for executive-level compensation

arrangements, more generally because executive

compensation plan design at the firm level typically

shares the same core features for all board-level

executives (albeit with some variation in key

parameters). Third, focusing on the compensation

practices of a single senior executive per company

simplifies our empirical analyses without risking any

significant loss of information.

13 RESEARCH DESIGN AND VARIABLE DEFINITIONSThis section provides an overview of our research

methods, explains the definition of performance and

compensation variables used in our empirical tests,

and summarises the data sources used to obtain the

inputs for these variables.

13.1 RESEARCH DESIGN

Empirical analyses are based on a sample of FTSE-100

firms. We require each firm in the final sample to

have an 11-year time-series of performance and CEO

compensation data beginning in 2003. 18 The sample

period starts in 2003 to coincide with improved

disclosure on executive compensation arrangements

following implementation of the Directors’

Remuneration Reporting Regulations with effect from

December 2002. We use this data to address our core

research questions as follows:

1 What is the degree of alignment between alternative

measures of periodic performance?

To address this question, we compute correlations

between all pairs of performance metrics. We

implement the correlation analysis using two

complimentary approaches. The first approach (pooled

analysis) combines data over time and across firms to

provide a global measure of the degree to which any

two performance metrics track each other. The second

approach (firm-level analysis) computes separate

firm-specific correlations using a time-series of

eleven observations per firm, which are then averaged

across firms.

2 To what extent is executive compensation aligned

with alternative measures of periodic performance,

with particular emphasis on the extent of alignment

between compensation and value creation?

We address this issue in a similar way to the previous

question by computing pooled and firm-level

correlations between CEO pay and the jth performance

metric, where j = TSR, FCF, RI, CFROI, ROA, ROE, and EPS

growth. We also conduct a series of supplementary

analyses where we partition the sample on the basis

of contracted performance metrics and then compare

measures of value creation, compensation, and a range

of additional dimensions including EPS growth relative

to the return on invested capital, earnings quality,

and share repurchase activity across the partitions

to provide further insights into the consequences of

prevailing compensation arrangements.

3 How do the performance metrics employed in

executive compensation plans align with the KPIs that

drive value at the individual company level?

We seek evidence on this question by comparing the

degree of alignment between the performance metrics

employed in CEO compensation contracts and the KPIs

disclosed by firms in their annual report and accounts.

Due to lack of disclosure in some firm-years, empirical

tests are based on the subset of observations where

KPI details are provided.

Data for our empirical tests are obtained from a

variety of sources. Financial statement and market

data are taken from Thomson Reuters Datastream,

which aggregates information from a range of

specialist sources including national governments,

the Organisation of Economic Cooperation and

Development, the Economic Intelligence Unit, the

International Monetary Fund, Worldscope, and Morgan

Stanley Capital. Analysts’ consensus EPS forecasts

are obtained from The Institutional Brokers’ Estimate

System (IBES), along with corresponding actual

EPS numbers that represent GAAP EPS adjusted for

various transitory and non-cash items. Finally, we use

companies’ published annual report and accounts

(accessed via Perfect Information) as the source

of information on CEO compensation payments,

contractual arrangements, and KPIs (where disclosed).

An inevitable consequence of constructing empirical

proxies based on financial statement and market

data is the presence of extreme observations.

Measures such as EPS growth that are influenced by

large charges such as impairments, write-offs, and

restructuring expenses, and cost of capital proxies that

rely on volatile market data are particularly susceptible

to extreme outcomes. Such observations pose a

significant challenge to the empirical analysis given

our relatively small sample size and our firm-level

analyses that are based on short time-series (11 years).

These data problems mirror those faced by any market

participant computing performance metrics using

19 An important feature of the capital maintenance perspective represented by equation (5) is that NICF includes the effect of fixed asset disposals, net changes in investments, and net changes in other assets in addition to capital expenditures. Inclusion of these additional components can lead to extreme (negative) values for NICF, which in turn can lead to negative realizations for FCFCash. Given uncertainty over specific elements included in net changes in other assets, in sensitivity tests we employed two alternative versions of equation (5). The first version sets FCFCash equal to NOCF minus the cumulative value of capital expenditure plus net cash flow from change in investments plus cash from fixed asset disposals. The second version sets FCFCash equal to net income minus interest income plus depreciation and amortization minus net gains on asset sales minus change in working capital accruals minus capital expenditures plus net cash flow from change in investments plus cash from fixed asset disposals. Results using both alternative measures are entirely consistent with those reported in Tables 7-10 using FCFCash. (Results are available from the authors on request.)

20 The CAPM and Fama-French three factor model has been subject to criticism in the academic literature (Mishra and O'Brien 2013, Kothari et al. 1995, Jegadeesh and Titman 1993, Carhart 1997, Griffin and Lemmon 2002, Daske et al. 2006)

21 Due to constraints on data availability, OAS is only computable for 145 observations relating to 17 firms. Supplementary tests using all three alternative cost of debt proxies yield results and conclusions that are entirely consistent with those reported below. Results of these supplementary tests are available from the authors on request. We are grateful to Mikkel Velin and Rogge Global Partners for help and advice with cost of debt calculations and for providing data for computing OAS..


published accounting data and market prices that

are subject to short-term volatility. Failure to address

the problem of extreme observations will confound

our analysis and skew resulting conclusions. Further

details of how we address the problem of extreme

observations are provided below.

13.2 VARIABLE DEFINITIONS

13.2.1 Performance metrics

Total shareholder return (TSR)

TSR reflects the total periodic return from holding a

share arising from both distributions (e.g., dividend

payments) and changes in the price of the share.

Gregory-Smith and Main (2012) compute annual TSR for

firm i during fiscal year t using Datastream’s return index

datatype:

where RetI is the daily Datastream return index (defined

as the theoretical growth in value of a shareholding

over a one-day period, assuming that dividends are

re-invested to purchase additional units of the stock),

and d1 (d2) is the last (first) day of fiscal year t. In

subsequent tests we focus on absolute TSR rather than

TSR benchmarked against a share index or a peer group.

The latter approach is the norm in CEO compensation

contracts in the UK and therefore our results should be

interpreted with this caveat in mind.

Free cash flow to the firm (FCF)

Although the conceptual definition of FCF to the firm

is unambiguous, a range of different approaches to

implementing this metric have been proposed (Adhikari

and Duru 2006). In addition to the standard textbook

approaches, investment practitioners tracking a small

number of stocks often apply a series of firm-specific

adjustments designed to provide a more refined

measure. The nature of our analysis is such that

idiosyncratic accrual adjustments using information

from the notes to the financial statements are not

feasible. By way of compromise, we use two short-cut

approaches to measuring FCF that are widely applied

in standard financial statement analysis and corporate

finance textbooks, as well as in the academic research

literature. The first approach follows Penman (2012) and

utilises data from the cash flow statement to produce a

cash flow-based estimate for FCF (FCFCash):

where NOCF is net operating cash flow (Worldscope

code WC04860) and NICF is net cash flow from

investments (WC04870). This approach provides

a capital maintenance perspective on free cash

flow insofar as it captures the amount of cash that

management may consume within a period without

reducing the value of the business (by adjusting net

operating cash flow for investing activities including

capital expenditures). 19 The starting point for our

second FCF measure is net income, which we then

adjusted as described in Damodaran (1996) and Brealey,

Myers and Marcus (1995) to produce an earnings-based

estimate (FCFIncome):

where FFO is funds from operations which is measured

as net income plus non-cash charges (WC04201), CAPEX

is total capital expenditure during the period (WC04601),

and D is cash dividends paid (WC04551). This approach

provides an all-inclusive perspective on free cash

flow by adjusting for both investing and financing

activities. Since both perspectives are extensively used

by management (Adhikari and Duru 2006), we report

results using both measures.

Residual income to the firm (RI)

Residual income to all capital providers in the company

is periodic profit less a charge for invested capital and is

computed using equation (3) from Part 1. The calculation

involves three key variables: net operating profit after

tax (NOPAT), invested capital (IC), and the weighted

average cost of capital (WACC). We defined NOPAT

as EBIT × (1 – Tax rate), where EBIT is earnings before

interest and tax (WC18191), and Tax rate is (WC08346).

Invested capital is equal to Net Fixed Assets (WC02501)

plus Current Assets (WC02201) minus Current Liabilities

(WC03101) minus Cash (WC02003). Finally, our firm- and

time-varying measure of WACC is computed as:

where Equity is the book value of shareholders’ equity

(WC03995), Debt is the book value of debt (WC03251),

Re is the cost of equity capital, Rd is the cost of debt

capital, and Tax rate is as defined above. We use the

CAPM (Sharpe 1964, Lintner 1965) to estimate Re and

then assess the sensitivity of the resulting values

to alternative estimation procedures including the

Fama-French three factor model (Fama and French

1993) and the implied cost of capital estimated via the

abnormal earnings growth model. 20 We set Rd equal to

the basis spread corresponding to the following bands

for the standard deviation of equity returns (∂t) (http://

people.stern.nyu.edu/adamodar/), where subscripts i

and t refer to firm and calendar year, respectively, and ∂

is computed using daily returns and then annualised for

each firm-calendar year:

Standard deviation categories

Basis spread (%)

≥ 0.00 to < 0.25 0.50

≥ 0.25 to < 0.50 1.00

≥ 0.50 to < 0.65 1.50

≥ 0.65 to < 0.80 2.00

≥ 0.80 to < 0.90 2.50

≥ 0.90 to < 1.00 3.00

≥ 1.00 to < 10.00 4.00

Supplementary tests designed to assess the

robustness of WACC to cost of debt measure utilised

three alternative methods. The first method sets Rd

equal to the weighted average yield on the firm’s

outstanding bonds:

where RY is the average redemption yield on the jth bond

issue and PB is market value of the jth bond issue as a

fraction of the aggregate market value of all J bonds in

issue at the corresponding date. The second method

uses credit spread (CS) calculated following Kabir et al.

(2013) to proxy for Rd:

where SP is the bond yield spread defined as the

difference between the yield on the jth bond issue and

the yield on an equivalent UK government benchmark

bond (i.e., similar maturity), measured in basis

points. The third approach uses the option adjusted

spread (OAS) to account for the imbedded option

risk component in bond spreads. The OAS measures

the yield spread that is not directly attributable to a

security's characteristics. 21

Cash flow return on investment (CFROI)

Boston Consulting Group/Holt Value Associates’ CFROI

measure for firm i in fiscal year t is defined as:

Gross cash flow is inflation-adjusted cash flows

available to all capital owners in the company (i.e. cash

flow before tax and investment), defined as:

where OCF is operating cash flow (WC04201), TCF is

cash taxes paid (WC04150), IPCF is cash interest paid

(WC04148), and IICF is cash interest income (WC04149).

Gross invested capital is the gross accumulated

investment provided by capital owners and is

measured as:

where NA is net fixed assets (WC02501), CA is current

assets (WC02201), CL is current liabilities (WC03101), and

Cash is cash and cash equivalents (WC02003).

Other earnings-based performance measures

Earnings per share (EPS) growth is calculated as

change in EPS between the current and previous period

divided by EPS in the previous period:

where EPS is earnings after taxes divided by the

weighted average number of shares outstanding

TSRit = Re tIid1 −Re tIid2( )−1⎡⎣ ⎤⎦×100

FCFitCash = NOCFit − NICFit

FCFitIncome = FFOit −CAPEXit −Dit

WACCit =Equityit

Equityit +Debtit×R

it

e⎛

⎝⎜

⎞

⎠⎟+

DebtitEquityit +Debtit

×Rit

d × 1−Tax rateit( )⎛

⎝⎜

⎞

⎠⎟

Ritd = RYij ×PBij( )

j=1

J

∑

CSit = SPij ×PBij( )j=1

J

∑

CFROIit =Gross cash flowit

Gross invested capitalit

Gross cash flowit = OCFit +TCFit + IPCFit − IICFit

Gross invested capitalit = NAit +CAit −CLit −Cashit

EPS growthit =EPSit − EPSit-1

EPSit-1

22 IBES actual EPS is defined to ensure consistency with analysts’ consensus earnings forecast for a given firm. Analysts typically forecast earnings before non-recurring or exceptional items. IBES reviews analysts’ treatment of individual earnings line items (e.g., restructuring charges) in their earnings forecast and adopts the majority treatment to define the numerator in their actual EPS metric. For example, if the majority of analysts for firm i (j) exclude (include) goodwill impairment charges in their earnings forecasts then actual EPS for firm i (j) will also exclude (include) this item.

23 Where companies do not disclose the maximum ward for a given compensation element, we substitute the sample median. We assume performance metrics are equally weighted for companies that use multiple performance metrics but do not disclose relative weights.


during the fiscal year. We define EPS as core earnings

per share based on actual earnings from IBES, which is

equivalent to GAAP earnings before transitory gains and

losses. 22 Core EPS is designed to capture underlying

or sustainable earnings performance. We report

results using core EPS to better capture underlying,

sustainable earnings performance.

We also use return on assets (ROA) and return on equity

(ROE). ROA is equal to:

where total assets are the sum of total current assets,

long term receivables, investment in unconsolidated

subsidiaries, other investments, net property plant

and equipment and other assets (WC02999). ROE is

defined as net income (WC01651) divided by the book

value of shareholders’ equity (WC03995):

13.2.2 Contractual performance measures

Information on the performance metrics used in

CEO compensation contracts are collected from the

remuneration report section of firms’ published annual

report and accounts. We focus exclusively on CEO

compensation arrangements and record information

separately for each compensation component (annual

bonus, deferred bonus, share options, performance

share plans, etc.). Details of all contracted performance

measures relating to fiscal year t are recorded including

financial, quantitative non-financial, and qualitative

non-financial metrics. Where multiple metrics are

employed, we collect information on the fraction of total

rewards linked with each measure when disclosed,

as well as all disclosed performance standards. Our

focus for fiscal year t is restricted to measures linked

with compensation paid, granted or outstanding for

that year; we do not record details of new performance

measures proposed for introduction in t + n.

13.2.3 CEO remuneration

The annual amount of compensation received by

CEOs is defined as the sum of base salary (Salary),

cash bonus (Bonus), equity incentives (Equity),

and pensions plus other benefits (Other). The

compensation literature is characterised by a lack of

on consensus on how CEO equity incentives should

be measured. For completeness, therefore, we use

three alternative methods to compute the Equity

component, yielding three corresponding measures

of total CEO compensation. Our first Equity measure

employs the realised value of equity incentives

(options and restricted shares) using figures reported

in the compensation table presented as part of the

remuneration report. This measure provides an ex

post perspective on CEO pay, insofar as it captures the

aggregate cash amount received by the CEO during

fiscal year t. As this figure is disclosed directly in the

remuneration report, it is typically the number on which

media discussion and shareholder debate anchors,

and accordingly it represents the primary focus of our

analysis.

Our second measure of Equity employs the grant date

fair value of equity incentives awarded during the

fiscal year. This measure captures the value of equity

incentives granted during fiscal year t as if all new

awards were exercisable with immediate effect and as

such provides an ex ante estimate of the value of CEO

services purchased by shareholders over the vesting

period. This is the value of equity incentives that

accountants use as a basis for computing the periodic

compensation expense charged against reporting

earnings, and the one which is most commonly

employed in academic research on CEO compensation.

Since firms are not required to disclose the grant date

fair value of equity incentives awarded during the

fiscal year, we estimate this figure using the method

proposed by Core and Guay (2002b). Specifically, option

fair values (C) are estimated using the Black-Scholes

(1973) method:

where S is share price on the day the option is granted,

K is the agreed exercise price, ∂ is the annual standard

deviation of share returns, T is the time to maturity, r

is the risk-free interest rate, and N(d) is the cumulative

normal distribution (i.e. the probability that a normally

distributed variable is less than d). Information on

exercise price and maturity is taken from firms’ annual

reports. Share price is obtained from Datastream

(price index type P). We estimate ∂ using the

annualised standard deviation of monthly share returns

(Datastream price index type PI) computed over the 60

preceding months. The risk free rate is approximated

by the yield on UK Treasury Bills with a maturity of

three months (Datastream UKTBTND). Similarly, the fair

value of performance shares (i.e., restricted stock) is

calculated as the maximum shares awardable under

the plan multiplied by share price at the fiscal year-end.

Although using the maximum number of awardable

shares can overstate grant date values, Fernandes et

al. (2013) demonstrate that results are not sensitive to

this choice.

Our third measure of Equity is defined as the grant

date fair value of equity incentives awarded during

the fiscal year as described above plus the change in

the value of all direct CEO equity holdings during the

corresponding period. Insofar as direct equity holdings

represent a non-trivial component of CEO wealth,

as well as a powerful means of aligning CEO and

shareholder interests, this approach provides a more

comprehensive perspective on the level and change in

CEO wealth during fiscal year t. This measure has been

widely adopted in the academic research literature

over the last decade. We compute the end-of-year

value of CEO equity holdings as the product of the

number of shares held by the CEO at annual report date

t multiplied by share price on the corresponding date.

Annual changes in the value of CEO equity holdings are

computed as the difference between holdings at fiscal

year-end t + 1 and fiscal year-end t.

13.2.4 Rewards linked with contracted performance measures

Two dimensions are relevant when examining the use

of performance measures in executive compensation

contract design: (a) the incidence of a particular

metric and (b) the fraction of variable compensation

contingent on that metric. Extant UK research and

survey evidence examining performance measures

employed in executive compensation contracts is

restricted to a binary analysis of the incidence of

performance measure usage. While informative, this

approach yields limited insights because it provides no

evidence on the relative importance of each metric in

determining total compensation outcomes.

To address this limitation we follow De Angelis and

Grinstein (2014) and estimate an ex ante measure of

performance-based compensation incentives defined

as the proportion of total incentive compensation

associated with the jth performance measure as

follows:

where Weight is the fraction of total compensation

linked to performance metric j in year t, Maximum value

of non-equity awards is the maximum reward payable

in annual bonus (e.g., 2 × base salary) in year t, Fair

value of maximum equity grant is the grant date fair

value of the maximum equity award payable for the kth

equity-based component (e.g., share matching plans,

share option plans, and performance share plans) in

year t, Total compensation is the maximum value of

annual compensation payable in year t, and w is the

contractual weight associated with the jth performance

metric in year t. Supplementary data on compensation

weights required to operationalise equation (17) are

collected from the remuneration report section of firms’

annual report and accounts. 23 Note that equation (17)

employs both the maximum potential bonus payable

and the grant date fair value of equity incentives

based on the maximum number of shares awardable.

Accordingly, this set of analyses provides evidence

on the fraction of maximum potential compensation

payments linked to a given performance metric rather

than the fraction of realised compensation linked to

that metric.

13.2.5 KEY PERFORMANCE INDICATORS

Disclosure of KPI information is voluntary and as a

consequence some firms provide limited information,

ROAit =Incomeit

Total assetsit

ROEit =Net Incomeit

Equityit

C = S ×N(d1)−K × e−rt ×N(d2 )

d1 =ln( SK)

σ × T+σ × T2

d2 = d1 −σ × T

Weight jt =Maximum value of non-equity awardst

Total compensationt

×wjt

+Fair value of maximum equity grantkt

Total compensationt

×wjkt

⎛

⎝⎜

⎞

⎠⎟

k=1

K

∑


particularly in the early part of the sample period.

(Systematic disclosure of KPI information was patchy

before 2006.) We identify KPI information by searching

firms’ annual report and accounts using the following

keyword list: “KPI”, “key performance indicator”, and

“critical success factor”.

14 SAMPLE, DATA, AND SUMMARY STATISTICS14.1 SAMPLE SELECTION

The sampling frame for our analysis is FTSE-100 index

constituents as at September 2013. To measure

associations between alternative performance

metrics and to assess the degree to which executive

compensation payments correlate with these

alternative metrics, we require firms to have a complete

11-year time-series of data required to compute all

our main performance metrics and compensation

variables for the period 2003 to 2013. Sixty-seven firms

from the initial FTSE-100 constituent list satisfied this

condition, from which we selected 30 firms to form our

final sample. The sampling approach was stratified by

industry to ensure broad coverage of FTSE-100 industry

groups. We sought to select firms in proportion to the

overall FTSE-100 sector representation but with the

additional condition that the sample should include a

minimum of two firms from each sector where possible.

Where more than two firms with available data in a

given sector were available, we selected the largest

firms based on market capitalisation as at September

2013. The decision to focus on a subset of available

firms reflected the data demands of our tests and in

particular the need to collect a significant amount of

information manually from firms’ published annual

reports and accounts. The final sample therefore

comprises 330 annual observations relating to 30

companies, although some of our supplementary tests

use fewer observations due to missing data for certain

variables.

A list of sample firms grouped by sector and ranked in

descending order by market capitalisation within each

sector is presented in Table 1. All ten industrial sectors

in the original FTSE-100 constituent list are represented

in the final sample. The three industry groups with the

highest representation in our sample are industrials with

approximately 16 percent of mean total compensation.

Consistent with the trend away from share options

toward restricted stock, share appreciation rights

and other types of LITP, share options account for a

smaller (zero) fraction of mean (median) total annual

compensation. Long term pay comprising options,

LTIPs and share matching plans represents 27 percent

of mean total annual compensation and 48 percent of

variable pay. Short-term bonuses account for 17 percent

of average annual pay, with annual payouts ranging

from zero to £3.3 million. Using the grant date value of

equity incentives awarded in the period, results in Panel

B using show that restricted shares and other forms

of performance share plan represent approximately

52 percent of mean total compensation. Share option

grants account for a small (zero) fraction of mean

(median) total annual compensation. Overall, equity

grants represent 57 percent of mean total annual

compensation and 77 percent of variable pay in Panel

B. Collectively, the evidence in Table 2 is consistent

with the continuing drive toward more emphasis on

variable pay (linked to performance) and as such these

results serve to highlight the central importance of

performance metric choice in the context of executive

compensation contract design.

Panels A and B in Figure 1 report CEO compensation

by year and sector, respectively, based on the grant

date fair value of equity incentives awarded during

the period. An upward trend in total compensation is

evident in Panel A over the sample period, although

some evidence of plateauing is apparent from 2010

onwards. Total compensation increases from an

average of £2.4 million in 2003 to £4 million in 2012.

It is noteworthy that no material reduction in total

compensation is apparent during the financial crisis

2008 to 2011 despite weak corporate performance

over this period (see Panel A in Figure 2). The relative

importance of individual compensation components

suggests a subtle redistribution from fixed salary

to equity-based incentives over the sample period,

consistent with continuing pressure for more

performance-related pay. The trend toward more

share-based pay masks a substantial reduction

in share option grants, which is more than offset

by an increase in restricted share plans and share

matching plans.

Panel B in Figure 2 reveals substantial variation in total

CEO compensation by sector. Health care is associated

with the highest average total CEO compensation at

£7.3 million per year, followed by basic materials with

£6.7 million, and oil and gas with £5.7 million. Sectors

with the lowest average level of CEO compensation

are consumer goods and technology with £3.1 million.

The relative importance of individual compensation

components also varies across industries, with a

higher (lower) total realised compensation associated

with a higher fraction of long-term variable pay (salary).

For example, whereas fixed salary accounts for only 11

percent of mean total compensation in the health care

sector, the comparable fraction in the consumer goods

TABLE 2Panel A: Realised values

Variable (£000) N Mean St. dev. Min Median Max

Salary 330 727 211 45 725 1,233

Annual bonus 330 644 491 0 550 3,300

Pension and other benefits 330 234 337 1 145 3,196

Realised value of share options 330 237 811 0 0 6,546

Realised value of restricted shares 330 358 1761 0 0 23,959

Total compensation 330 2,199 2,159 60 1,702 25,209

Panel B: Granted values for equity

Variable (£000) N Mean St. dev. Min Median Max

Total value of share option plan 330 162 526 0 0 7,833

Total value of performance share plan 330 1,831 2,227 0 1,346 23,192

Total value of share matching plan 330 130 478 0 0 4,576

Total compensation 330 3,726 2,657 60 3,073 24,317

Notes:All compensation data are collected using remuneration report disclosures. Values for share options, restricted shares and total compensation relate to the realized value of equity incentives. This measure represents an ex post perspective on CEO pay insofar as it captures the aggregate cash amount received by the CEO during fiscal year t. Results in Panel B are based on the grant date fair value of equity incentives awarded during the fiscal year.

TABLE 1

Notes:The sampling frame is FTSE 100 index constituents as at September 2013. We require firms to have a complete 11-year time-series of data required to compute our main performance metrics and compensation variables for the period 2003 to 2013. Sixty-seven firms from the initial FTSE 100 constituent list satisfied this condition, from which we selected 30 firms using a stratified sampling approach by industry whereby firms were sampled in proportion to the overall FTSE 100 sector representation but with the additional condition that the sample should include a minimum of two firms from each sector wherever possible. Where more than two firms with available data in a given sector were available, we selected the largest firms based on market capitalisation as at September 2013.

Basic Materials

Rio Tinto

Anglo American

Consumer Goods

Associated British Foods

Persimmon

Consumer Services

Pearson

Sainsbury (J)

Next

Marks & Spencer Group

Whitbread

Financials

Standard Chartered

Aviva

Aberdeen Asset Management

Hammerson

Industrials

Rolls-Royce Holdings

BAE Systems

CRH

Wolseley

Bunzl

Aggreko

Weir Group

Rexam

Babcock International

Technology

Sage group

Health Care

Glaxosmithkline

Smith & Nephew

Telecommunications

BT Group

Oil & Gas

BG Group

Tullow Oil

Utilities

Centrica

United Utilities Group

nine firms (30 percent), consumer services with five firms

(17 percent), and financials with four firms (13 percent).

14.2 DESCRIPTIVE STATISTICS FOR COMPENSATION PLAN DESIGN

Summary statistics for the components of CEO

compensation are reported in Table 2 using realised

values for equity incentives (Panel A) and the grant

date fair value of equity incentives (Panel B). The

median (mean) CEO received £1.7 (£2.2) million per year

in total compensation during the sample period. Total

realised compensation varies dramatically, ranging

from £0.6 million (Wolseley, 2009) to £25.2 million

(Tullow Oil, 2008). 24 Average base salary is £0.7 million

and accounts for approximately 33 percent of realised

annual total compensation. Variation in annual salary is

relatively narrow, ranging from a low of £0.5 million to

a high of £1.2 million. The most significant component

of realised CEO compensation is restricted shares and

other forms of performance share plan, representing

24 The fair value of total granted compensation ranges from £0.6 million (Wolseley, 2009) to £24.3 million (Rolls Royce, 2008)..

2000000

1600000

1200000

800000

400000

0

£000/Percentage

Basic Mate

rials

Consumer G

oods

Consumer S

ervices

Financials

Health C

are

Industrials

Oil and G

as

Technology

Telecom

muicatio

ns

Utilitie

s

FCF (Cash)

FCF (Income)

RI (NOPAT)

CFROI (%)

1.40

1.20

1.00

0.80

0.60

0.40

0.20

0.00

Percentage

Basic Mate

rials

Consumer G

oods

Consumer S

ervices

Financials

Health C

are

Industrials

Oil and G

as

Technology

Telecom

muicatio

ns

Utilitie

s

TSR

ROA

ROE

EPS growth

38 | www.cfauk.org

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

8000

7000

6000

5000

4000

3000

2000

1000

0

Basic Mate

rials

Consumer G

oods

Consumer S

ervices

Financials

Health C

are

Industrials

Oil and G

as

Technology

Telecom

muicatio

ns

Utilitie

s

Percentage

£000

Basic Mate

rials

Consumer G

oods

Consumer S

ervices

Financials

Health C

are

Industrials

Oil and G

as

Technology

Telecom

muicatio

ns

Utilitie

s

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

7000

6000

5000

4000

3000

2000

1000

0

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Percentage

£000

Time

Share based

Pension and other benefits

Annual Bonus

Salary

Time

Share based


Annual Bonus

Salary

Share based


Annual Bonus

Salary

Share based


Annual Bonus

Salary

FIGURE 1: MEAN CEO COMPENSATION BASED ON FAIR VALUE OF EQUITY INCENTIVES GRANTED DURING THE PERIOD PRESENTED BY TIME AND SECTOR

Panel A: CEO compensation by time

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

8000

7000

6000

5000

4000

3000

2000

1000

0

Basic Mate

rials

Consumer G

oods

Consumer S

ervices

Financials

Health C

are

Industrials

Oil and G

as

Technology

Telecom

muicatio

ns

Utilitie

s

Percentage

£000

Basic Mate

rials

Consumer G

oods

Consumer S

ervices

Financials

Health C

are

Industrials

Oil and G

as

Technology

Telecom

muicatio

ns

Utilitie

s

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

7000

6000

5000

4000

3000

2000

1000

0

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Percentage

£000

Time

Share based


Annual Bonus

Salary

Time

Share based


Annual Bonus

Salary

Share based


Annual Bonus

Salary

Share based


Annual Bonus

Salary

FIGURE 1: MEAN CEO COMPENSATION BASED ON FAIR VALUE OF EQUITY INCENTIVES GRANTED DURING THE PERIOD PRESENTED BY TIME AND SECTOR

Panel B: CEO compensation by sector

0.50

0.45

0.40

0.35

0.30

0.25

0.20

0.15

0.10

0.05

0.00

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

400000

350000

300000

250000

200000

150000

100000

50000

0

RI a

nd

FC

F £

00

0

CFR

OI (

%)

Year

RI (NOPAT) FCF (Cash) CFROI FCF (Income)

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

0.30

0.20

0.10

0.00

-0.10

-0.20

-0.30

Pe

rce

nta

ge

Year

TSR ROA ROE EPS growth

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

0.120

0.100

0.080

0.060

0.040

0.020

0.000

Pe

rce

nta

ge

Year

Cost of equity Cost of debt WACC

0.50

0.45

0.40

0.35

0.30

0.25

0.20

0.15

0.10

0.05

0.00

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

400000

350000

300000

250000

200000

150000

100000

50000

0

RI a

nd

FC

F £

00

0

CFR

OI (

%)

Year


2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

0.30

0.20

0.10

0.00

-0.10

-0.20

-0.30

Pe

rce

nta

ge

Year


2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

0.120

0.100

0.080

0.060

0.040

0.020

0.000

Pe

rce

nta

ge

Year


FIGURE 2: MEDIAN PERFORMANCE METRICS BY SECTOR AND TIME

Panel A: Performance metrics by time

0.50

0.45

0.40

0.35

0.30

0.25

0.20

0.15

0.10

0.05

0.00

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

400000

350000

300000

250000

200000

150000

100000

50000

0

RI a

nd

FC

F £

00

0

CFR

OI (

%)

Year


2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

0.30

0.20

0.10

0.00

-0.10

-0.20

-0.30

Pe

rce

nta

ge

Year


2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

0.120

0.100

0.080

0.060

0.040

0.020

0.000

Pe

rce

nta

ge

Year


Notes:Variable definitions are as follows: FCF(Cash) is defined from a capital maintenance perspective and is equal to net operating cash flow minus net cash flow from investments; FCF(Income) is defined from an all-inclusive per-spective and is equal to net income plus non-cash charges, minus total capital expenditure and cash dividends; RI (NOPAT) is net operating profit after tax less a capital charge equal to the product of book value of net assets and a firm- and time-varying estimate of the weighted average cost of capital; CFROI is the ratio of gross cash flows to gross capital invested. TSR is equal to , where ri is the daily Datastream return index (defined as the theoretical growth in value of a share holding over a one-day period, assuming that dividends are re-invested to purchase additional units of the stock), and d1 (d2) is the last (first) day of fiscal year t. EPS growth is equal to the change in EPS from year t - 1 to t, scaled by EPS at time t - 1. ROA is equal to oper-ating profit divided by total assets, while ROE is equal to net income scaled by book value of shareholders’ funds. WACC is the weighted average costs of capital defined as the cost of equity (computed using CAPM) weighted by the fraction of equity in total capital plus the after-tax cost of debt weighted by the fraction of debt in total capital.

FIGURE 2: MEDIAN PERFORMANCE METRICS BY SECTOR AND TIME

Panel B: Performance metrics by sector (medians)

2000000

1600000

1200000

800000

400000

0

£000/Percentage

Basic Mate

rials

Consumer G

oods

Consumer S

ervices

Financials

Health C

are

Industrials

Oil and G

as

Technology

Telecom

muicatio

ns

Utilitie

s

FCF (Cash)

FCF (Income)

RI (NOPAT)

CFROI (%)

1.40

1.20

1.00

0.80

0.60

0.40

0.20

0.00

Percentage

Basic Mate

rials

Consumer G

oods

Consumer S

ervices

Financials

Health C

are

Industrials

Oil and G

as

Technology

Telecom

muicatio

ns

Utilitie

s

TSR

ROA

ROE

EPS growth

www.cfauk.org | 39

Notes:Variable definitions are as follows: FCF(Cash) is defined from a capital maintenance perspective and is equal to net operating cash flow minus net cash flow from investments; FCF(Income) is defined from an all-inclusive perspective and is equal to net income plus non-cash charges, minus total capital expenditure and cash dividends; RI (NOPAT) is net operating profit after tax less a capital charge equal to the product of book value of net assets and a firm- and time-varying estimate of the weighted average cost of capital (see below); CFROI is the ratio of gross cash flows to gross capital invested. TSR is equal to , where ri is the daily Datastream return index (defined as the theoretical growth in value of a share holding over a one-day period, assuming that dividends are re-invested to purchase additional units of the stock), and d1 (d2) is the last (first) day of fiscal year t. EPS growth is equal to the change in EPS from year t - 1 to t, scaled by EPS at time t - 1. ROA is equal to operating profit divided by total assets, while ROE is equal to net income scaled by book value of shareholders’ funds. (Median ROE is capped at 40 percent for charting purposes. The extreme median ROE value for the Telecommunications sector is driven by observations for BT Group, in particular 2009 and 2010.) WACC is the weighted average costs of capital defined as the cost of equity (computed using CAPM) weighted by the fraction of equity in total capital plus the after-tax cost of debt weighted by the fraction of debt in total capital.

www.cfauk.org | 41

Consistent with prior survey evidence (Deloitte 2010,

KPMG 2013, PwC 2013), EPS is the most commonly used

income metric. Accounting returns such as ROA and

ROE are also popular (33 percent of firm-years where

accounting measures are employed). Sales and cash

flow metrics also feature, although their incidence

varies by sector. A significant fraction of firms in the

consumer service and health care sectors employ both

metrics, while reliance on sales (cash flow) is particularly

prominent in the financials (telecommunications and

industrials) sector. Other sectors place little weight on

these metrics. Accounting-based categories such as

margins and cost reduction targets feature infrequently.

Results in Table 4 reveal firms in most sectors typically

employ between one and three accounting metrics. The

exceptions are financials (where a broader set of metrics

including income, sales, accounting returns, margins,

cost, gearing and other is employed) and to a lesser

degree firms in the health care and customer services

sectors. A notable feature of Table 4 is the absence of

accounting-based metrics that benchmark performance

against the cost of capital. In particular, residual income

and its cousins such as EVA© have failed to gain traction

despite their theoretical superiority.

Further information concerning the relative mix of

non-financial performance measures is reported in

Table 5, where metrics are grouped into four generic

categories: employee, customer, environment, and

ethics. Conditional on CEO compensation being aligned

with at least one non-financial metric, employee-

and customer-based targets are the most popular

choice, followed by environmental performance and,

finally, ethics. Not surprisingly, non-financial metrics

vary by industry. For example, employee (safety) and

environmental targets feature prominently in the oil and

gas and utilities sectors, while customer-focused targets

are more common in the consumer services, financials,

telecommunications, and utilities sectors. There is some

evidence of an increasing trend in the use of employee

and environmental metrics.

Findings reported in Tables 3 and 4 confirm prior

evidence that EPS and TSR are the most popular metrics

used to align CEO compensation with firm performance.

To shed further light on the relative importance of these

two measures, we follow De Angelis and Grinstein

(2014) and estimate the proportion of total potential

performance-related compensation associated

sector is 20 percent; and while performance share plans

represent 72 percent of average total compensation

in the oil & gas sector, they account for less than 60

percent in the consumer goods sector.

Evidence on the metrics linking CEO compensation to

performance is reported in Tables 3 to 5. Performance

metrics are classified into three generic categories in

Table 3: accounting-based metrics (e.g., EPS, ROA, ROE,

etc.), market-based metrics (e.g., TSR), and non-financial

metrics (e.g., customer satisfaction). Consistent with

evidence reviewed in Section 7, most firms in most

years link one or more components of CEO pay to

accounting- and market-based performance, with the

former being relatively more popular: 97 percent of

firm-year observations employ at least one accounting

metric compared with 83 percent that use at least one

market-based metric. Untabulated results reveal that

accounting-based metrics are more frequently used

in short-term bonus plans whereas market-based

measures (either in isolation or combined with

accounting measures) are more commonly employed

in share-based plans. Whereas the accounting-based

category includes a variety of metrics (see Table 4),

the market-based category is dominated by TSR.

Non-financial performance metrics are less prevalent in

relative terms but are nevertheless widely employed in

absolute terms (63 percent of firm-years).

The popularity of accounting metrics is consistently

high across time and sector (with the exception of oil

and gas), whereas the use of market-based measures

displays greater variation over time and across sectors.

Non-financial metrics display the highest degree of

variation across sectors, as well as a marked upward

trend over the sample period. By 2013, the majority (80

percent) of sample firms linked at least one aspect of

CEO pay to non-financial performance.

Table 4 provides more granularity for accounting-based

performance metrics. Income measures are the most

popular type of accounting measure (94 percent of

firm-years where accounting measures are employed).

Performance metrics by category:

N Accounting Market Non-financial

Total sample 330 0.97 0.83 0.63

By industry:

Basic Materials 22 0.95 1.00 0.91

Consumer Goods 22 1.00 0.45 0.41

Consumer Services 55 1.00 0.67 0.40

Financials 44 1.00 0.68 0.75

Health Care 22 1.00 0.95 0.86

Industrials 99 1.00 0.92 0.47

Oil & Gas 22 0.55 1.00 0.77

Technology 11 1.00 0.82 0.73

Telecommunications 11 1.00 1.00 1.00

Utilities 22 1.00 0.91 1.00

By year:

2003 30 0.97 0.67 0.53

2004 30 0.93 0.80 0.53

2005 30 0.97 0.83 0.50

2006 30 0.97 0.87 0.67

2007 30 0.97 0.87 0.63

2008 30 0.97 0.90 0.67

2009 30 0.97 0.90 0.63

2010 30 0.97 0.90 0.63

2011 30 0.97 0.83 0.67

2012 30 0.97 0.77 0.67

2013 30 1.00 0.77 0.80

TABLE 3

Notes:Findings are based on the sample of 30 firms and 11 years of data per firm. Information on the performance metrics used in CEO compensation contracts are collected from the remuneration report section of firms’ published annual report and ac-counts. We focus exclusively on CEO compensation arrangements and record information separately for each compensation component (annual bonus, deferred bonus, share options, performance share plans, etc.). Details of all contracted perform-ance measures used in determining compensation for fiscal year t are recorded and classified into three generic categories: accounting-based metrics (e.g., EPS, FCF, ROE, residual income, etc.), market-based metrics (e.g., TSR), and non-financial metrics (e.g., customer satisfaction).

Accounting performance metric by category:

N Incomemeasures Sales Accounting

ReturnsCashflows Margins Cost

reduction RI Gearing Other

Total sample 319 0.94 0.21 0.33 0.30 0.08 0.07 0.00 0.05 0.26

By industry:

Basic Materials 21 0.62 0.00 0.38 0.00 0.00 0.00 0.00 0.00 0.48

Consumer Goods 22 0.95 0.00 0.27 0.14 0.00 0.00 0.00 0.00 0.50

Consumer Services 55 1.00 0.55 0.44 0.35 0.00 0.02 0.00 0.00 0.20

Financials 44 0.82 0.45 0.50 0.07 0.25 0.45 0.00 0.23 0.57

Health Care 22 0.91 0.32 0.14 0.41 0.64 0.00 0.00 0.00 0.05

Industrials 99 1.00 0.04 0.31 0.52 0.01 0.00 0.00 0.05 0.07

Oil & Gas 12 0.92 0.00 0.92 0.00 0.00 0.08 0.00 0.00 0.08

Technology 11 1.00 0.18 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Telecommunications 11 1.00 0.27 0.00 1.00 0.00 0.00 0.00 0.00 0.00

Utilities 22 1.00 0.00 0.00 0.00 0.00 0.05 0.00 0.05 0.77

By year:

2003 29 0.93 0.14 0.28 0.17 0.00 0.10 0.00 0.03 0.31

2004 28 0.96 0.14 0.29 0.18 0.07 0.07 0.00 0.07 0.29

2005 29 0.93 0.21 0.31 0.17 0.10 0.07 0.00 0.07 0.31

2006 29 0.93 0.24 0.34 0.21 0.10 0.07 0.00 0.07 0.31

2007 29 0.93 0.21 0.38 0.24 0.07 0.07 0.00 0.07 0.31

2008 29 0.97 0.17 0.34 0.28 0.10 0.07 0.00 0.03 0.28

2009 29 0.97 0.17 0.31 0.38 0.07 0.07 0.00 0.03 0.24

2010 29 0.97 0.17 0.28 0.38 0.07 0.07 0.00 0.03 0.21

2011 29 0.93 0.28 0.31 0.38 0.10 0.07 0.00 0.07 0.24

2012 29 0.90 0.31 0.38 0.45 0.10 0.10 0.00 0.03 0.21

2013 30 0.90 0.23 0.40 0.47 0.10 0.03 0.00 0.03 0.17

TABLE 4

40 | www.cfauk.org


present results using both metrics. 26

Median TSR, ROA and ROE over the sample period are

15 percent, seven percent, and 19 percent respectively.

Median core annual EPS growth is 10 percent. As

with our value creation metrics, all four variables

are characterised by extreme observations. Finally,

the median annual cost of equity (debt) estimate is

eight (five) percent over the sample period and the

resulting median WACC is 6.4 percent. While these

average values are plausible, estimation error caused

by extreme share market volatility leads to implausible

(e.g., negative) values for both the cost of equity and

WACC. Extreme cost of capital estimates feed through

into extreme values for RI via equation (3).

Panel B of Table 6 seeks to address the problem of

extreme or implausible values. For RI we replace

extreme observations or missing (negative) values

for cost of debt and tax rate (cost of equity and

book equity). For ROE, we replace two negative book

equity observations with their corresponding lagged

values.27 (Further details of the adjustment process are

available from the authors on request.) The resulting

distributions for cost of equity and WACC display

more reasonable maximum and minimum values: the

maximum (minimum) adjusted value for cost of equity

is 17.9 (0.0) percent, while the corresponding value

for WACC is 16.9 (0.1) percent. We do not winsorize

extreme values for other variables in Table 6 because

these values do not necessarily reflect measurement

error; and we do not delete outliers to preserve sample

size. Instead, we conduct the majority of subsequent

analyses using nonparametric statistical tests. We

also conduct additional robustness tests where

appropriate to assess the sensitivity of our results to

deletion of extreme observations. Nevertheless, we

stress the need for caution when interpreting statistical

associations computed using a relative small sample

size such as that employed here.

Figure 2 reports median values for performance

metrics by time (Panel A) and sector (Panel B) based

on the adjusted data reported in Panel B of Table 6.

directly with each metric. To reiterate, this analysis

measures the maximum fraction of potential future

performance-related payments linked to a given metric

rather than the fraction of realised performance-related

compensation. Findings should therefore be interpreted

as providing ex ante evidence on the relative importance

of EPS and TSR.

For the mean (median) firm-year in our sample

approximately 25 (four) percent of the maximum value

of performance-related compensation awardable in the

period is linked directly to EPS growth. Skewness in the

findings reflects a small set of sample firms that place

very high weight on EPS growth. The analysis suggests

that while the use of EPS growth targets is widespread

(Table 4), the total value of awardable pay linked to

EPS performance is more variable. We attribute this

variation to EPS metrics being more frequently employed

in short-term bonus plans (particularly following

the demise of share option plans with EPS vesting

conditions), which on average account for a modest

proportion of total performance-related pay incentives

(Table 2 and Panel B in Figure 1). Firms in the industrials

and technology sectors are associated with the highest

compensation weight on EPS growth. There is some

evidence of an increase over the sample period in the

weight on EPS growth but the trend is not linear.

The mean (median) firm-year is associated with

a 49 (32) percent compensation weight on TSR,

reflecting the dominance of equity incentives in

total performance-related pay and the fact that TSR

metrics are widely applied to the equity component of

compensation. The weight on TSR is relatively stable

over the sample period but varies considerably across

sectors. Inter-industry variation is expected given the

variation in equity incentives reported in Panel B of Figure

1. Sectors with the highest compensation weight linked to

TSR include oil and gas, health care, and basic materials.

Whether linking CEO pay closely with TSR incentivises

(and to a lesser extent EPS growth) rewards value

creation appropriately is a separate question on which

our subsequent analysis aims to shed light. 25

15 CORRELATION BETWEEN ALTERNATIVE PERFORMANCE METRICSThis section presents evidence on the degree of

alignment between a suite of value-based performance

measures and a set of other accounting- and

market-based metrics commonly used to evaluate firm

performance and senior executive performance. The

group of value-based metrics comprises FCF, RI, and

CFROI, while the residual group of metrics consists of

TSR, ROA, ROE, and EPS growth.

15.1 SUMMARY STATISTICS FOR PERFORMANCE METRICS

Summary statistics for all performance metrics and

components thereof are reported in Panels A and

B of Table 6. Panel A presents statistics using raw

(unadjusted) variables. The median sample firm

generates positive free cash flow and residual income.

However, median values mask considerable variation

in performance, with some firm-years associated with

large negative values (i.e., value destruction). Similarly,

while the median CFROI suggests a healthy annual

return of approximately 33 percent, considerable

variation in performance is evident. Note also that

distributions for all value-based metrics contain

extreme values that skew results and could influence

conclusions. This is particularly apparent for the

FCFCash metric where one extreme negative value

(-£39.1 billion) skews the entire distribution to the left.

(See footnote 18 for a discussion of why FCFCash is

susceptible to large negative values.) The magnitude

of this extreme value is likely to affect correlations with

other performance metrics and with measures of CEO

compensation variables, even when nonparametric

methods are used. Accordingly, subsequent results

should therefore be interpreted with this caveat in

mind. All else equal, we expect findings reported for

FCFIncome to be more reliable but for completeness we

Notes:Findings are based on the subset of sample firm-years where CEO compensation is directly aligned with at least one non-financial performance metric.

Non-financial performance metrics by category:

N Employee Customer Environment Ethics

Total sample 208 0.26 0.25 0.13 0.04

By industry:

Basic Materials 20 0.45 0.00 0.00 0.00

Consumer Goods 9 0.11 0.11 0.11 0.00

Consumer Services 22 0.41 0.41 0.36 0.00

Financials 33 0.24 0.52 0.00 0.00

Health Care 19 0.00 0.00 0.00 0.00

Industrials 47 0.13 0.00 0.00 0.04

Oil & Gas 17 0.53 0.00 0.47 0.00

Technology 8 0.00 0.13 0.00 0.00

Telecommunications 11 0.00 1.00 0.00 0.00

Utilities 22 0.59 0.64 0.45 0.27

By year:

2003 16 0.19 0.31 0.00 0.00

2004 16 0.13 0.25 0.00 0.00

2005 15 0.20 0.27 0.07 0.00

2006 20 0.25 0.25 0.15 0.05

2007 19 0.26 0.26 0.16 0.05

2008 20 0.30 0.25 0.15 0.10

2009 19 0.32 0.26 0.16 0.11

2010 19 0.37 0.26 0.21 0.05

2011 20 0.30 0.30 0.15 0.05

2012 20 0.25 0.25 0.15 0.00

2013 24 0.29 0.17 0.17 0.00

TABLE 5

25 In additional untabulated tests we partitioned firms by their average ex ante compensation weight associated with EPS and TSR during the sample window and examined the overall incidence of performance measure categories across those partitions. Not surprisingly, the incidence of accounting- (market-) based performance metrics is greater for firms that attach higher ex ante compensation weight to EPS (TSR) and as such the results provide a useful validity check on the method for calculating compensation weights proposed by De Angelis and Grinstein (2014). Findings also reveal that the popularity of accounting-based metrics (relative to market and non-financial measures) is higher for all portfolios regardless of the ex ante weight attached to EPS. This pattern serves to further illustrate the dominance of accounting-based metrics as proxies for management and firm performance. While the relative popularity of accounting-based metrics is consistent with these measures shielding executives from uncontrollable market-level factors, it also increases the risk of gaming and myopic behaviour highlighted in section 8.

26 Closer inspection reveals this observation is not a data error. In untabulated tests where we trim or winzorize this value, the resulting distribution for FCFCash is more consistent with that for FCFIncome.

27 ROE for BT Group in 2010 remains extreme (724 percent) even after making this adjustment and as a result we treat this value as missing in subsequent tests.


computed using 11 years of data per firm. Results are

broadly consistent using the two approaches although

some notable differences are apparent. The majority of

correlations in both panels are statistically significant at

the 10 percent level or better.

Several important conclusions emerge from Table

7. First, pairwise correlations between the group of

value-based metrics are positive (with the exception of

FCFCash and CFROI). For example, FCFIncome and RI display

correlation coefficients ranging from 0.43 (Panel A)

to 0.39 (Panel B); FCFIncome and RI also exhibit strong

positive correlations with CFROI in both Panel A using

pooled data (0.43 and 0.32, respectively) and Panel B

based on mean firm-specific time-series correlations

(0.25 and 0.21, respectively). Correlations based on

FCFCash are uniformly weaker, reflecting the impact of

an extreme value in the FCFCash distribution. Collectively,

results are consistent with all three value-based

metrics capturing a similar underlying value-creation

construct measured over a 12-month window. With

no correlation coefficients exceeding 0.5, however,

findings nevertheless suggest these metrics capture

different aspects of the value creation phenomenon.

The low level of alignment in absolute terms highlights

the importance of performance metric selection even

when a consistent value-based perspective is adopted.

Panel A: Raw data

Variable N Mean St. dev. Min Median Max

FCFCash 330 -70805 3923793 -39100000 168979 11000000

FCFIncome 330 407383 1300489 -6906977 149300 9514000

RI 305 728336 1254629 -3191199 281065 7464298

CFROI 330 0.331 0.989 -4.557 0.327 7.302

TSR 330 0.160 0.349 -0.813 0.146 1.822

ROA 305 0.073 0.088 -1.135 0.068 0.278

ROE 305 0.212 0.786 -9.472 0.187 2.871

EPS growth 330 0.356 2.933 -0.983 0.102 43.975

Cost of equity 330 0.076 0.044 0.000 0.079 0.179

Cost of Debt 330 0.034 0.021 0.005 0.045 0.071

WACC (CAPM) 306 0.062 0.052 -0.624 0.064 0.169

Panel B: Adjusted data

Variable N Mean St. dev. Min Median Max

FCFCash 330 -70805 3923793 -39100000 168979 11000000

FCFIncome 330 407383 1300489 -6906977 149300 9514000

RI 330 686629 1247213 -3299770 268398 7464298

CFROI 286 0.514 0.713 -1.916 0.376 4.471

TSR 330 0.160 0.349 -0.813 0.146 1.822

ROA 330 0.071 0.058 -0.172 0.065 0.278

ROE 330 0.282 0.915 -9.472 0.182 11.083

EPS growth 330 0.356 2.933 -0.983 0.102 43.975

Cost of equity 330 0.076 0.044 0.000 0.079 0.179

Cost of Debt 330 0.034 0.021 0.005 0.045 0.071

WACC (CAPM) 330 0.064 0.034 0.001 0.064 0.169

TABLE 6

Notes:Variable definitions are as follows: FCFCash is defined from a capital maintenance perspective and is equal to net operating cash flow minus net cash flow from investments; FCFIncome is defined from an all-inclusive perspective and is equal to net income plus non-cash charges, minus total capital expenditure and cash dividends; RI is net operating profit after tax less a capital charge equal to the product of book value of net assets and a firm- and time-varying estimate of the weighted average cost of capital (see below); CFROI is the ratio of gross cash flows to gross capital invested. TSR is equal to refer TSR equation on page 32, where ri is the daily Datastream return index (defined as the theoretical growth in the value of a shareholding over a one-day period, assuming that dividends are re-invested to purchase additional units of the stock), and d1 (d2) is the last (first) day of fiscal year t. EPS growth is equal to the change in EPS from year t - 1 to t, scaled by EPS at time t - 1. ROA is equal to operating profit divided by total assets, while ROE is equal to net income scaled by book value of shareholders’ funds. WACC is the weighted average costs of capital defined as the cost of equity (computed using CAPM) weighted by the fraction of equity in total capital plus the after-tax cost of debt weighted by the fraction of debt in total capi-tal. Panel A presents statistics using raw (unadjusted) variables. Panel B reports results using adjusted values of RI and ROE that account for extreme or implausible observations.

The first chart in Panel A reports time-series trends

for value-based metrics (FCF, RI and CFROI). With the

exception of the FCFCash metric, all measures reveal

a dip in performance that coincides with the onset of

the financial crisis in 2007/2008, followed by a rebound

in 2009 or thereafter. Similar patterns are also evident

in the second chart in Panel A that reports results for

TSR, ROA, ROE and EPS growth. The negative spike

around 2007 to 2009 is particularly apparent for TSR,

reflecting the general decline in global stock markets

during this period.

The final chart in Panel A of Figure 2 presents the time

trend for WACC and its components. A significant

decline in WACC is evident from around 10 percent in

2007 to less than six percent from 2009 onwards.

The decline is driven primarily by a reduction in the

cost of equity, although a slight downward trend in

the cost of debt is also apparent between 2007 and

2010. Results suggest that lower cost of capital (rather

than growth in underlying business cash flows) was

the primary driver of value creation improvements

between 2009 and 2011, and that these gains may

have reflected macroeconomic factors beyond

management’s control.

Panel B of Figure 2 compares median performance

by sector. Significant variation in value creation is

evident, with basic materials, telecommunications,

and heathcare demonstrating particularly strong

performance. Financials also display high RI, although

this is likely to be driven by structural differences in

the way invested capital is measured for banks and

other financial institutions relative to non-financial

firms. Significant industry variation in measured

performance is also apparent for TSR, ROA, ROE and

EPS growth, consistent with structural differences in

factors such as asset utilisation, operating margins,

and accounting treatments.

Collectively, results reported in Figure 2 highlight the

importance of benchmarking performance evaluations

by industry and time-period norms to better isolate the

components of performance over which management

exercise material control.

15.2 CORRELATION BETWEEN PERFORMANCE MEASURES

This section reports evidence on the degree of

alignment between alternative measures of periodic

performance. Specifically, we examine the degree of

association between alternative value-based metrics,

and between value-based metrics and other measures.

Table 7 reports pairwise nonparametric (Spearman)

correlations. We focus on Spearman correlations

to mitigate the impact of extreme observations

and we scale RI and FCF metrics by lagged market

capitalisation to eliminate the confounding effects

of firm size that would otherwise induce spurious

positive correlation between these unscaled measures,

and to ensure comparability with other growth- and

return-based measures. Panel A presents correlations

computed for the pooled sample while Panel B reports

the mean of individual firm-level correlation coefficients

NotesSee Table 6 for variable definitions. Panel A reports correlations computed using the cross-sectional and time-series pooled sample. Panel B reports the mean value of firm-specific correlations computed using 11 observations per firm. NS indicates correlations that are not significant at the 0.10 level or better.

Scaled FCF (Cash) Scaled FCF (Income) Scaled RI (NOPAT) CFROI

Panel A: Pooled sample

Scaled FCFCash 1.00

Scaled FCFIncome 0.24 1.00

Scaled RI 0.13 0.43 1.00

CFROI -0.04 NS 0.43 0.32 1.00

TSR -0.08 NS 0.13 0.16 0.10 NS

ROA 0.13 0.16 0.33 0.34

ROE 0.10 0.22 0.49 0.45

EPS growth 0.09 NS 0.24 0.17 0.15

Panel B: Mean of firm-level correlations

Scaled FCFCash 1.00


Scaled RI 0.14 0.39 1.00

CFROI -0.09 0.25 0.21 1.00

TSR -0.06 0.08 0.14 0.22

ROA 0.05 0.23 0.58 0.39

ROE 0.06 0.19 0.52 0.29

EPS growth 0.10 0.18 0.13 0.13

TABLE 7


growth are annual values compounded over three-year

windows). Correlations among all value-based

metrics when measured over multi-year periods

are qualitatively similar or larger in magnitude to

those reported in Table 7. In contrast, associations

between value-based metrics and both TSR and EPS

growth are statistically indistinguishable from zero

at conventional level of significance. These findings

provide even stronger evidence than that reported in

Tables 7 and 8 of a disconnect between value creation

and traditional performance metrics used in executive

compensation contracts.

Overall the findings reported in Tables 7-9 cast doubt on

the legitimacy of performance metrics commonly used

in executive compensation contracts. Results suggest

that motivating senior executives to grow EPS and TSR

does not necessarily generate economic returns to

capital providers due to poor alignment between these

metrics and measures of periodic value creation.

16 EXECUTIVE COMPENSATION AND VALUE CREATIONEvidence presented in section 14 identifies EPS growth

and TSR as the most commonly employed metrics

The second conclusion emerging from Table 7 is that

the two dominant performance metrics employed

in executive compensation contracts (i.e., EPS

growth and TSR) exhibit weak associations with all

three value-based metrics. For example, correlation

coefficients reported in Panels A and B of Table 7

between TSR and FCFIncome, and between TSR and

RI do not exceed 0.16. Similar results are evident for

correlations between EPS growth and RI, and between

EPS growth and CFROI. Meanwhile, correlations

between FCFCash and EPS do not exceed 0.1, while

corresponding values for TSR are negative. Even the

highest correlations reported between FCFIncome and

EPS (0.24, Panel A) and CFROI and TSR (0.22, Panel

B) are modest in absolute terms. Collectively, these

results cast serious doubt on the extent to which TSR

and EPS reflect economic returns to capital providers

during the reporting period and hence call into question

firms’ reliance on these metrics as key determinants of

CEO compensation.

The third notable finding in Table 7 is that traditional

accounting return on investment metrics such as ROA

and ROE exhibit relatively strong and robust positive

correlations with all three value-based metrics (with

the exception of FCFCash). For example, correlation

coefficients for ROE range from 0.22 to 0.45 for FCFIncome

and CFROI, respectively, in Panel A (0.19 to 0.52 for

FCFIncome and RI, respectively, in Panel B). Similarly,

correlations for ROA range from 0.16 to 0.34 for FCFIncome

and CFROI, respectively, in Panel A (0.23 to 0.58 for

FCFIncome and RI, respectively, in Panel B). Despite the

dysfunctional investment behaviour that ROA and ROE

can induce, these results suggest both measures are

capable of capturing a significant degree of variation in

economic returns.

We further explore the link between alternative

measures of periodic performance using the following

ordinary least squares (OLS) regression to assess the

power of commonly employed performance metrics to

explain variation in value creation:

where Equation (18) is one of our three value-based

performance metrics (k = FCF, RI, and CFROI), TSR

and EPS are as previously defined, and ROIp is one

of our two return on investment metrics (p = ROA or

ROE). Model summary statistics for equation (18) are

reported in Table 8. Panel A presents results based

on a single pooled regression while Panel B presents

mean values computed using firm-level regressions

estimated with 11 years of data per firm. Results are

in line with those reported in Table 7. Results for the

pooled regression models reported in Panel A reveal

very low explanatory power of commonly employed

performance metrics for value creation: the highest

R-squared value is only 16 percent (model 3 for RI) and

in most cases R-squareds do not exceed five percent.

While firm-level regressions reported in Panel B are

associated with higher R-squared values, at best

the vector of non-value-based metrics explain only

60 percent of the variation in periodic value creation

(models 3 and 4 in Panel B for RI) and more typically

the explanatory power is around 50 percent. Further,

ROE and ROA contribute the majority of explanatory

power: coefficient estimates on TSR and EPS are low in

magnitude and statistically indistinguishable from zero

in many cases.

Findings reported in Tables 7 and 8 are based on

performance measured over a 12-month period.

To assess the robustness of these findings to the

length of the performance measurement window, we

repeat the correlation analysis based on performance

measured over two- and three-year intervals. Results

are reported in Table 9. Panel A reports pooled

correlations based on two-year non-overlapping

performance windows (i.e., 2003 and 2004, 2005 and

2006, 2007 and 2008, etc.). All performance measures

are recomputed for the corresponding two-year period

(TSR and EPS growth are annual values compounded

over two-year windows). Panel B reports pooled

correlations based on three-year non-overlapping

performance windows (i.e., 2003-2005, 2006-2008,

etc.). All performance measures are recomputed for

the corresponding three-year period (TSR and EPS

Value Creationitk =ϕ0 +ϕ1TSRit +ϕ2EPSit + ϕ3ROIit

p +εit

Notes:See Table 6 for variable definitions. Panel A reports regression coefficients and summary statistics estimated using the cross-sectional and time-series pooled sample. Panel B reports the mean value of coefficient estimates and model summary statistics from firm-specific regressions estimated using 11 observations per firm. ***, ** and * indicates significance at the one, five and 10 percent levels, respectively.

CFROI Scaled RI Scaled FCFCash Scaled FCFIncome

Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Model 7 Model 8

Panel A: Pooled regressions

EPS growth -0.008 -0.012 * 0.000 -0.001 ** 0.007 *** 0.006 *** 0.000 0.000

TSR -0.045 0.045 0.011 0.031 ** -0.086 ** -0.062 0.01 0.015

ROA 2.185 *** 0.497 *** 0.616 *** 0.142

ROE 0.048 0.012 * 0.012 0.010

Constant 0.354 *** 0.495 *** 0.024 ** 0.053 *** -0.01 0.027 ** 0.024 * 0.031 ***

Adjusted R2 0.03 0.01 0.16 0.04 0.06 0.03 0.01 0.01

Panel B: Means of firm-level regressions

EPS growth 0.412 0.448 0.006 -0.003 0.072 ** 0.057 ** 0.012 0.026

TSR -0.023 -0.044 -0.015 -0.007 -0.065 ** -0.063 ** 0.001 0.002

ROA 1.563 1.515 *** -0.746 0.346

ROE 0.819 0.380 *** 0.150 0.164 **

Constant 0.352 0.334 0.01 0.014 0.007 0.001 0.014 0.006

Adjusted R2 0.50 0.48 0.61 0.60 0.41 0.42 0.40 0.41

TABLE 8

NotesSee Table 6 for variable definitions. Panel A reports pooled correlations based on two-year non-overlapping performance windows (i.e., 2003 and 2004, 2005 and 2006, 2007 and 2008, etc.). All performance measures are recomputed for the corre-sponding two-year period (TSR and EPS growth are annual values compounded over two-year windows). Panel B reports pooled correlations based on three-year non-overlapping performance windows (i.e., 2003-2005, 2006-2008, etc.). All per-formance measures are recomputed for the corresponding three-year period (TSR and EPS growth are annual values com-pounded over three-year windows). NS indicates correlations that are not significant at the 0.10 level or better.

Scaled FCF (Cash) Scaled FCF (Income) Scaled RI (NOPAT) CFROI

Panel A: Pooled sample, three-year window

Scaled FCFCash 1.00


Scaled RI 0.32 0.65 1.00

CFROI -0.01 NS 0.32 0.29 1.00

TSR -0.20 0.01 NS 0.01 NS 0.10 NS

ROA 0.16 0.20 0.33 0.50

ROE 0.16 0.33 0.48 0.47

EPS growth -0.06 NS 0.06 NS -0.10 NS 0.10 NS

Panel B: Pooled sample, three-year window

Scaled FCFCash 1.00


Scaled RI 0.37 0.71 1.00

CFROI -0.06 NS 0.31 0.28 1.00

TSR -0.21 -0.04 NS -0.08 NS 0.13 NS

ROA 0.17 0.19 0.28 0.49

ROE 0.18 0.36 0.44 0.48

EPS growth -0.03 NS 0.08 NS -0.12 NS 0.10 NS

TABLE 9


to 30 percent correlation between compensation and

periodic value creation.

We assessed the robustness of results reported in

Table 10 by repeating the analysis using two- and

three-year non-overlapping performance windows.

Performance metrics are as defined in Table 9 while

aggregate compensation variables are defined as

annual CEO pay cumulated over the corresponding two-

and three-year intervals. Results are similar to those

presented in Table 9. Specifically, while cumulative

CEO pay displays a material positive association with

value creation over these multi-year windows, between

50 and 60 percent of the variation in compensation

(regardless of specific definition) is unrelated to each

value-based proxy. Correlation coefficients between

cumulative CEO pay and both TSR and EPS growth over

these multi-year windows are similar to those reported

in Table 10.

Collectively the results reported in this section provide

a degree of comfort but also create cause for concern.

On the positive side, findings reveal a robust material

positive association between CEO pay and two

measures of periodic value creation (RI and FCF) that

have strong theoretical support. The correlations for RI

and FCF are at least as strong as those documented

for TSR and EPS using pooled tests, and in some cases

are significantly more pronounced than EPS and TSR

based on firm-specific correlations. These findings

suggest that current CEO pay structures incentivise

and reward important aspects of value creation (even

though the specific performance metrics used in

executive contracts are not directly aligned with value

creation in many cases). More troubling, however,

is the evidence that (i) a large fraction of CEO pay

appears unrelated to periodic value creation and (ii)

key aspects of compensation consistently correlate

with performance metrics such as TSR and EPS growth

whose theoretical link with value creation is fragile. On

the basis of these findings we conclude that while UK

compensation practices have come a long way since

Sir Richard Greenbury published his landmark report

in1995, the journey is far from complete. Note also that

since our analysis focuses on the largest London Stock

Exchange-listed firms that tend to follow best-practice

guidelines most assiduously, our findings likely reflect

an upper bound on the magnitude of the link between

executive pay and fundamental value creation. We

therefore view the issue of performance metric

linking executive compensation to firm performance,

while results presented in section 15 highlight the weak

association between these contracted performance metrics and established measures of economic returns to capital providers. An open question is the extent to which executive remuneration correlates with fundamental value creation to capital providers, as opposed to short-term measures of performance whose link with value creation is more questionable.

To shed light on this question Table 10 reports correlations between annual CEO pay and alternative measures of periodic performance. Consistent with previous analyses, we report Spearman correlations estimated using the pooled sample (Panel A) as well as mean firm-level correlation coefficients estimated using 11 years of data per firm. Findings are presented for three alternative approaches to measuring CEO compensation. The first approach (Realised) measures the equity-based component of pay using the realised value of shares exercised during the period (as reported in the remuneration report). The second approach (Granted) measures the equity-based element of pay using the grant date fair value of shares awarded (but not necessarily vested) during the period. The third approach (CEO wealth) measures the periodic change

in total CEO wealth, defined as salary plus realised

bonus plus the grant date fair value of shares awarded

during the period plus the change in the market value of

CEO direct equity holdings. For the Realised and Granted

approaches Table 10 reports separate correlations for

total pay (salary plus bonus plus equity incentives plus

pensions and other), total variable pay (bonus plus

equity incentives), and equity-only incentives.

Findings reported in Panel A based on pooled

correlations reveal the following insights. With the

exception of ROE and CFROI (total realised and granted),

CEO compensation correlates positively with firm

performance regardless of the specific metric used.

Findings suggest that efforts by UK regulators and

governance activists over the last two decades to align

executive pay and corporate performance have been

at least partially successful. Nevertheless, correlations

are generally low in absolute terms, suggesting a

weak link between rewards to senior executives

and aspects of corporate success as reflected in a

range of well-established performance metrics. For

example, the highest correlation in Panel A is 0.29

(EPS growth with total granted variable pay). These

findings are consistent with both extant academic

evidence highlighting statistically significant but

economically weak association between CEO pay and firm performance, and concern raised by governance activists and the financial media about the perception

of pay without performance. Of particular relevance

to this study, the magnitude of the association

between CEO compensation and our portfolio of value

creation proxies is limited. For example, correlations for

FCFIncome are in the region of 0.2 whereas comparable

associations with RI range between 0.1 and 0.2.

Meanwhile, correlations based on FCFCash and CFROI

are negligible. Regardless of the specific measure of

value creation used and the different approaches used

to measure CEO pay, these results suggest that much

of the variation in compensation payments to CEOs of

FTSE-100 firms does not appear to reflect differences in

established measures of value creation.

Reflecting the widespread use of performance

conditions linked to TSR and EPS growth, findings

reported in Panel A document robust positive

associations between these two metrics and all

elements of CEO pay (total, variable, and equity

incentives) using both realised and granted measures

of CEO compensation. The change in total CEO wealth

during the period (i.e., including the value of direct share

holdings) also correlates positively with EPS (0.16) and

TSR (0.20). In most cases the correlation coefficients

for EPS and TSR are statistically indistinguishable from

(larger than) those reported for FCFIncome and RI (FCFCash

and CFROI). In contrast, the association between pay

and traditional return on investment metrics such as

ROA and ROE is typically low.

Results presented in Panel B of Table 10 based on

the mean coefficients from firm-specific time-series

correlations lead to similar conclusions insofar as no

performance metric yields a correlation coefficient

above 0.29 for either the change in total CEO wealth

or any element of CEO pay (total, variable, and equity

incentives) measured using either realised or granted

estimates of CEO compensation. In contrast with the

findings in Panel A, correlations based on FCFIncome

and RI are significantly larger than those documented

for TSR and EPS in a number of cases. In relative terms,

therefore, these firm-level correlations suggest that

CEO rewards are linked more closely to certain value

creation measures. In absolute terms, however, the

message is a consistent one across the two panels:

the degree of association between CEO pay and returns

to all capital providers appears low, with at best a 20

Realised Granted

Total Total variable Equity Total Total variable Equity Total wealth

Panel A: Pooled correlations

Scaled FCFCash 0.10 0.07 0.02 0.06 0.02 -0.06 -0.03

Scaled FCFIncome 0.21 0.25 0.19 0.20 0.26 0.05 0.18

Scaled RI 0.12 0.15 0.14 0.11 0.21 0.12 0.10

CFROI -0.01 0.03 0.06 -0.03 0.03 0.04 0.11

TSR 0.13 0.16 0.17 0.13 0.19 0.11 0.20

ROA 0.04 0.07 0.12 0.00 0.04 0.01 0.17

ROE -0.06 -0.03 0.03 -0.10 -0.02 -0.04 -0.01

EPS growth 0.18 0.20 0.20 0.22 0.29 0.13 0.16

Panel B: Mean of firm-level correlations

Scaled FCFCash 0.20 0.16 0.09 0.19 0.09 -0.05 -0.03

Scaled FCFIncome 0.25 0.27 0.15 0.29 0.29 0.01 0.19

Scaled RI 0.18 0.19 0.20 0.18 0.24 0.20 0.26

CFROI -0.03 0.01 0.05 -0.01 0.06 0.09 0.14

TSR -0.04 -0.01 0.02 0.01 0.11 0.16 0.14

ROA 0.02 0.07 0.13 0.07 0.20 0.18 0.19

ROE 0.05 0.09 0.17 0.05 0.16 0.15 0.18

EPS growth 0.04 0.04 0.03 0.19 0.22 0.10 0.04

TABLE 10

Notes:See Table 6 for variable definitions. Findings are reported for three alternative approaches to measuring CEO compensation. The first approach (columns 2-4) is based on the realized value of equity-based incentives exercised during the period (as reported in the remuneration report). The second approach (columns 5-7) measures equity incentives based on the grant date fair value of shares awarded (but not vested) during the period. The third approach (final column) measure the change in total CEO wealth, defined as salary plus realized bonus plus grant date fair value of shares awarded during the period plus the change in the market value of CEO direct equity holdings. For the realized and granted approaches, we report results for total compensation (salary plus bonus plus equity incentives plus pensions and other), total variable pay (bonus plus equity incentives), and equity incentives. Panel A reports correlations computed using the cross-sectional and time-series pooled sample. Panel B reports the mean value of firm-specific correlations computed using 11 observations per firm.


higher for the high EPS weight portfolio, although the

difference is not statistically significant at conventional

levels. These results provide qualitative support for

claims that EPS performance conditions encourage

share buybacks aimed at increasing EPS regardless of

whether or not they create value for shareholders.

17.3 EARNINGS MANAGEMENT

Research highlights how performance-related

compensation arrangements can create powerful for

incentives for management to manipulate reported

earnings. All else equal, greater use of earnings-based

performance metrics such as EPS in executive

compensation contracts has been linked to a higher

propensity for earnings management behaviour. It

is an empirical question whether reliance on EPS

performance conditions in CEO compensation

contracts is associated with opportunistic

accounting choices designed to maximise short-term

compensation outcomes. We explore this question

by partitioning firm-year observations according to

the compensation weight on EPS and then testing for

differences in earnings management behaviour across

high and low EPS weight portfolios.

Our proxies for earnings management are based on the

discretionary accrual model developed by Jones (1991)

and implemented using the following cross-sectional

OLS regression estimated by year and industry group:

where, ACC is total operating accruals, equal to the

change in non-cash working capital minus depreciation

and amortization, REV is the change in total revenue,

TA is total assets, and subscripts i and t represent firms

and time, respectively. The residuals ( ) from equation

(19) represent the portion of total accruals not explained

by drivers of underlying economic activity. We

construct two proxies for earnings management based

on the residuals from equation (19). Our first earnings

management proxy is the signed residual ( ). All else

equal, we expect accounting manipulation to result in

income-increasing accounting choices on average, as

reflected in more positive values of .

A fundamental property of accounting accruals is

that overstatements (understatements) made in one

period inevitably unwind in future periods leading to

compensating understatements (overstatements). This

choice in executive compensation arrangements as

work-in-progress.

17 SUPPLEMENTARY ANALYSIS Theory and evidence highlights how EPS performance

conditions can lead executives to engage in gaming

and other dysfunctional behaviour. A natural question

given the prevalence of EPS performance conditions in

our sample is whether these targets cause FTSE-100

executives to take decisions that threaten returns to

capital providers. This section explores the impact

of EPS performance conditions in three settings. We

begin by examining the link between EPS growth

and compensation plan design conditional on the

level of return on invested capital (ROIC) relative to

cost of capital (WACC), followed by analyses of share

repurchase behaviour and earnings quality conditional

on the compensation weight attached to EPS growth.

It is important to stress that due to our small sample

size, the following analyses should be interpreted as

providing qualitative evidence rather than statistically

rigorous conclusions.

17.1 VALUE DESTRUCTION

Following Mauboussin (2006), we partition firm-year

observations into those where ROIC > WACC and those

where ROIC < WACC, and then examine EPS growth. The

numerator in the ROIC ratio is equal to net operating

profit after tax (NOPAT), defined as EBIT × (1 – Tax

rate) with EBIT equal to earnings before interest and

tax (WC18191) and Tax rate equal to (WC08346); the

denominator is equal to Net Fixed Assets (WC02501)

plus Current Assets (WC02201) minus Current Liabilities

(WC03101) minus Cash (WC02003). High EPS growth is

value destroying and leads to a lower price-earnings

ratio where ROIC < WACC. An important question

is whether CEO compensation contract design

encourages EPS growth in general and in particular

where ROIC < WACC.

Results reported in Panel A of Table 11 provide

qualitative evidence that EPS performance conditions

in executive compensation contracts influence EPS

growth when ROIC > WACC. For example, a higher

incidence of EPS-based performance metrics and a

greater compensation weight on EPS performance

is apparent for the high EPS growth portfolio. In this

scenario, use of EPS performance conditions is more

likely to be aligned with value creation. Note, however,

that differences in EPS incidence and weight are not

statistically significant at conventional levels and as

such the impact of explicit EPS performance targets is

uncertain when ROIC > WACC.

Panel B reports results for firm-years where ROIC <

WACC, again partitioned into high and low EPS growth

portfolios. If the use of EPS-based targets motivates

executives to take value-destroying decisions we

would expect reliance on EPS performance metrics to

be greater in the high EPS growth portfolio. Findings

provide some support for this view. CEO compensation

contracts for observations in the high EPS growth

portfolio are associated with both a statistically

higher incidence of EPS performance conditions and

a statistically larger median weight on EPS targets.

(The mean compensation weight on EPS is also larger

in the high EPS growth partition although differences

are not statistically significant.) These findings support

for claims that linking compensation outcomes to

EPS growth can encourage management to engage

in value-destroying behaviour. Consistent with this

interpretation, the median price-earnings (enterprise

value-to-EBITDA) ratio for the high EPS growth portfolio

in Panel B is significantly lower than the corresponding

rate for the low EPS growth portfolio.

An additional result worthy of note in Table 11 is the

high overall reliance on EPS performance conditions

when ROIC < WACC regardless of realised EPS growth.

The high absolute incidence of EPS incentives (> 60

percent of cases) where ROIC < WACC is troubling.

Results suggest that the ubiquitous nature of EPS

performance conditions coupled with the sticky nature

of compensation contract design is problematic insofar

as firms are unable switch off EPS growth incentives

when conditions demand.

17.2 SHARE REPURCHASE ACTIVITY

An additional concern over the widespread use of

EPS conditions is that such targets create incentives

for management to favour share buybacks that

mechanically increase EPS but which may not be value

enhancing in the long run (Bens et al. 2002, Hribar et

al. 2006, Young and Yang 2011). To explore this concern

we partition our sample on the basis of the ex ante

compensation weight on EPS and then test whether

repurchase activity varies across high and low EPS

weight partitions. Results reported in Table 12 provide

some support for the view that EPS performance

conditions encourage buybacks. For example, the

incidence of buybacks is almost 1.5 times greater

among firms in the high EPS incentive weight portfolio:

repurchases occur in 22 percent of firm-years among

the high weight sample compared with just 16 percent

of firm-years in the low EPS weight sample (difference

significant at ten percent level using a one-tailed test).

Similarly, the repurchase yield (aggregate value of

shares repurchased during the fiscal year scaled by

beginning-of-period market capitalisation) is 42 percent

Notes:Return on capital invested (ROIC) is equal to net operating profit after tax (NOPAT) scaled by invested capital. Statistical significant is assessed using a one-tailed Wilcoxon two-sample test. Firm-years are first partitioned on the basis of ROIC relative to the weighted average cost of capital (WACC). The resulting two subsamples are then partitioned by median EPS growth. Statistical significance is assessed using a one-tailed Wilcoxon two-sample test. P/E is the price-earnings ratio com-puted four months after the balance sheet date. EV/EBITDA is the enterprise value-to-EBITDA ratio computed four months after the balance sheet date, where EV is equal to the market value of equity plus the book value of debt.

Median Median EPS Compensation weight:

EPS partition N P/E EV/EDITDA EPS incidence Mean Median

Panel A: ROIC > WACC

High EPS growth 124 16.16 14.48 0.79 0.29 0.11

Low EPS growth 124 15.16 14.01 0.78 0.24 0.04

Statistically significant: No No No No No

Panel B: ROIC > WACC

High EPS growth 41 13.76 10.81 0.78 0.23 0.05

Low EPS growth 41 16.38 14.73 0.66 0.18 0.00

Statistically significant: Yes Yes Yes No Yes

TABLE 11

Notes:Firm-years are partitioned into three categories (high, moderate and low) according to the weight on EPS growth computed using the method from De Angelis and Grinstein (2014). The incidence of share repurchase activity is the fraction of firm-years in the corresponding portfolio that repurchase shares in the corresponding fiscal year. Mean yield is the value of shares repurchased during the fiscal year scaled by market capitalization, averaged across all observations in the corresponding portfolio. Statistical significance is assessed using a one-tailed Wilcoxon two-sample test.

Repurchase activity:

EPS portfolio N Incidence Mean yield

High EPS weight portfolio 163 0.22 0.010

Low EPS weight portfolio 107 0.16 0.007

Statistically significant: Yes No

TABLE 12

ACCit = γ0 +γ1ΔREVit /TAit−1 +γ2PPEit /TAit−1 +εit


misalignment between the non-financial drivers of

business value and the performance metrics used to

incentivise and reward CEOs. In particular, one third of

the 183 firm-years where non-financial performance

metrics are listed among the suite of KPIs fail to

align CEO compensation with the corresponding

measure(s). Why a significant fraction of firms fail to

align CEO compensation with metrics that have been

explicitly identified by the board as critical measures of

organisational success is unclear and puzzling.

Evidence that compensation contracts fail to link

CEO pay directly with disclosed (non-financial) KPIs

while that the same time providing strong incentives

to increase dimensions of performance such as TSR

whose link with corporate strategy is less apparent

supports the moderate correlations between CEO pay

and value creation documented in Table 10. Having

identified key drivers of value, why many firms then

elect not to align CEO compensation incentives and

rewards directly with these factors remains something

of a mystery to us.

reversing property has led academics to focus on the

absolute value of periodic accruals as an alternative

measure of earnings management: high absolute

discretionary accrual activity may capture both

earnings management in the current period as well

as the reversal of manipulations undertaken in prior

periods. Accordingly, we use the absolute magnitude

of the residual from equation (19) (| |) as a second

measure of earnings management.

Average values for signed and absolute discretionary

accruals partitioned by EPS compensation weight are

reported in Panels A and B of Table 13, respectively.

Results using signed discretionary accruals provide

suggestive evidence consistent with earnings

management activity. Both mean and median

discretionary accruals are more positive in the high

EPS weight portfolio, although the difference in

medians is not significant at conventional levels. No

significant difference is also evident across high and

low EPS weight portfolios in Panel B of Table 13 for

absolute discretionary accruals. Overall, the results

in Table 13 suggest either that EPS performance

targets do not create incrementally powerful earnings

management incentives or that our proxies for earnings

management are too noisy to detect predicted effects

(Dechow et al 1995).

18 ALIGNMENT BETWEEN PERFORMANCE MEASURES AND KPisAn important goal of executive incentive schemes is to

encourage CEOs to focus on aspects of performance

that link directly with their firm’s strategic objectives.

Information disclosed in firms’ annual report and

accounts on corporate strategy and business model

by UK-listed firms provides insights into firm-specific

factors identified as core drivers of business success.

Key performance indicators (KPIs) represent the

bridge between corporate objectives and strategy

implementation. To the extent the set of KPIs disclosed

by management in the annual report and accounts

are reasonable and controllable by management, one

might expect to observe a high degree of overlap

between these metrics and the performance measures

employed in executive compensation contracts. This

section provides descriptive evidence on the extent of

this linkage.

Table 14 presents data on KPIs disclosed in firms’

annual report and accounts, classified into accounting,

market, and non-financial categories. The first row

reports results for the pooled sample. Conditional on a

firm disclosing information about KPIs in a given fiscal

year, findings highlight the importance of accounting

and non-financial measures relative to market metrics.

Income-based measures are the most popular

accounting KPI, followed by sales and cash flows.

Overall, 100 percent of disclosers specify at least one

accounting-based KPI. Corresponding frequencies for

market and non-financial metrics are 29 percent and

82 percent, respectively. Comparing this evidence with

information on the performance metrics that determine

CEO pay (see Table 3) yields several conclusions.

First, firms often elucidate strategy and business

model execution using accounting information,

although the direction of causality is unclear (i.e., do

accounting numbers drive strategic thinking or do

accounting metrics represent the language of strategy

implementation?).

Second and notwithstanding the alignment between

accounting performance measures and KPIs, results

suggest a material disconnect between the metrics

purported to drive business success and the

measures used to incentivise and reward executives.

For example, while only 29 percent of firms refer to

market-based KPIs, over 80 percent of firms align

executive compensation directly to market-based

metrics (see Table 3). Finally, while evidence from

Table 3 reveals that the incidence of non-financial

performance metrics significantly lags the incidence

accounting- and market-based performance in

executive compensation plans, findings in Table

14 demonstrate that firms identify non-financial

KPIs almost as frequently as accounting measures

(82 percent versus 100 percent, respectively) and

considerably more frequently that market measures

(82 percent versus 29 percent, respectively). Indeed,

CEO compensation contracts fail to link pay with

non-financial performance in 33 percent of the 183

firm-years where at least one non-financial KPI is

disclosed in the annual report and accounts.

Table 15 provides further evidence on the extent of

the disconnect between KPIs and the performance

metrics that determine CEO compensation. Of the

224 firm-years where KPI information is disclosed,

75 cases (33.5 percent) are associated with apparent

Notes:Firm-years are partitioned into three categories (high, moderate and low) according to the weight on EPS growth computed using the method from De Angelis and Grinstein (2014). Signed and absolute discretionary accruals reported in panel A and B are scaled by lagged total assets. Discretionary accruals are computed using a cross-sectional version of the model proposed by Jones (1991), estimated separate for each industry-year combination. Statistical significance is assessed using a one-tailed Wilcoxon two-sample test.

TABLE 13

Panel A: Signed discretionary accruals

EPS portfolio N Mean Median


Low EPS weight portfolio 97 -0.02 -0.01

Statistically significant: Yes No

Panel B: Absolute discretionary accruals

EPS portfolio N Mean Median


Low EPS weight portfolio 97 0.07 0.05

Statistically significant: No No

Notes:Findings for KPIs are conditional on firms electing to provide information in their annual report and accounts (disclosure of KPIs is voluntary in the UK). KPI information is identified by searching firms’ annual report and accounts using the following keyword list: “KPI”, “key performance indicator”, and “critical success factor”.

TABLE 14 Accounting-based metrics:

Income measures Sales Accounting

ReturnsCashflows Margins Cost

reductionResidualincome Gearing Other Market Non-

financial

Total sample 0.79 0.57 0.38 0.49 0.29 0.17 0.00 0.13 0.38 0.29 0.82

By industry:

Basic Materials 1.00 0.00 0.50 0.36 0.00 0.50 0.00 0.50 0.93 0.93 0.93

Consumer Goods 0.70 0.70 0.60 0.60 0.20 0.00 0.00 0.60 0.20 0.00 0.90

Consumer Services 0.94 0.94 0.26 0.37 0.37 0.09 0.00 0.03 0.37 0.00 0.69

Financials 0.69 0.28 0.56 0.13 0.56 0.03 0.00 0.00 0.56 0.47 0.78

Health Care 1.00 0.93 0.07 0.47 0.13 0.00 0.00 0.00 0.00 0.60 0.13

Industrials 0.70 0.67 0.64 0.72 0.40 0.19 0.00 0.15 0.34 0.09 0.90

Oil & Gas 0.38 0.06 0.00 0.63 0.00 0.63 0.00 0.19 0.00 0.81 1.00

Technology 1.00 1.00 0.00 1.00 0.00 0.00 0.00 0.00 0.00 0.00 0.88

Telecommunications 1.00 0.00 0.00 1.00 0.00 0.00 0.00 0.00 0.00 0.00 1.00

Utilities 0.84 0.58 0.00 0.00 0.16 0.26 0.00 0.05 0.84 0.42 1.00

By time:

2003 0.00 1.00 0.50 0.00 1.00 0.50 0.00 0.00 0.00 0.00 0.50

2004 0.33 0.67 0.33 0.33 0.67 0.67 0.00 0.33 0.33 0.00 0.67

2005 0.50 0.67 0.33 0.33 0.67 0.33 0.00 0.33 0.33 0.00 0.50

2006 0.80 0.55 0.40 0.40 0.20 0.15 0.00 0.10 0.30 0.25 0.75

2007 0.77 0.50 0.35 0.38 0.19 0.19 0.00 0.12 0.38 0.31 0.73

2008 0.81 0.59 0.30 0.41 0.26 0.15 0.00 0.11 0.33 0.30 0.78

2009 0.83 0.55 0.34 0.45 0.28 0.14 0.00 0.10 0.34 0.31 0.79

2010 0.83 0.55 0.31 0.59 0.28 0.17 0.00 0.10 0.34 0.31 0.86

2011 0.86 0.61 0.43 0.57 0.29 0.14 0.00 0.11 0.43 0.32 0.89

2012 0.76 0.56 0.40 0.60 0.32 0.16 0.00 0.12 0.52 0.32 0.92

2013 0.79 0.59 0.48 0.55 0.31 0.17 0.00 0.17 0.41 0.28 0.90


Several caveats are appropriate when interpreting

results and conclusions described above. First,

empirical analyses are conducted using a sample

of FTSE-100 firms and as such care is required when

seeking to generalise findings to the boarder population

of UK-listed equities. Since our analysis focuses on the

largest publicly traded firms that typically comply with

best-practice governance and remuneration guidelines,

we suspect that our findings reflect an upper bound

on the strength of the link between executive pay and

fundamental value creation. On the other hand, it is

possible that agency problems are more acute for such

entities and that as a result the disconnect between

CEO pay and value creation may be less apparent

for smaller firms. Second, our analyses focus on raw

performance measures whereas firm performance

is often benchmarked against a share index or peer

group for the purposes of determining executive pay. It

is possible that relative performance evaluation yields

closer alignment with value creation and that as a

result our findings understate the degree of association

between pay and value for all capital providers. Finally,

the analysis is subject to the usual caveats regarding

interpretation of statistical findings generally, and

in particular where statistical methods are applied

to relatively sparse data. We seek to address these

limitations by conducting a series of sensitivity tests

designed to assess the robustness of our findings and

conclusions. Results from these supplementary tests

are entirely consistent with those reported in the main

body of the report. Nevertheless, caution is still required

when interpreting statistical associations based on

small sample sizes.

Notes:Findings for KPIs are conditional on firms electing to provide information in their annual report and accounts (disclosure of KPIs is voluntary in the UK). KPI information is identified by searching firms’ annual report and accounts using the fol-lowing keyword list: “KPI”, “key performance indicator”, and “critical success factor”. Figures in parentheses refer to cell frequencies as a fraction of the total sampling disclosing KPI information (N = 224).

Non-financial KPI

Yes No Total

CEO pay linked explicitly

to non-financial

performance metric

Yes122

(54.46)

14

(6.25)

136

(60.71)

No61

(27.23)

27

(12.05)

88

(39.29)

Total183

(81.70)

41

(18.30)

224

(100.00)

TABLE 15

» Performance metrics that are commonly used in CEO

compensation contracts (e.g., EPS, TSR, ROA and

ROE) display relatively low correlation (< 0.5) with

theoretically superior measures of periodic value

creation such as FCF and RI;

» CEO pay measured from a range of perspectives also

displays low correlation (< 0.3) with firm performance

regardless of the specific performance metric

employed. These results support prior evidence

that CEO compensation outcomes are only loosely

associated with firm value;

» In relative terms, the correlation between CEO

compensation and value creation metrics such as RI

and FCF (computed using an all-inclusive approach)

is at least as strong as for contracted performance

metrics such as EPS and TSR. (Note, however, that

conclusions for FCF are sensitive to the specific

definition employed: when FCF is measured using

a capital maintenance approach we observe little

correlation between CEO pay and value creation);

» Lack of close alignment between contracted

performance metrics and measures of fundamental

value creation raise concern about prevailing

executive incentive structures among large UK-listed

firms;

» We find some (albeit statistically weak) evidence

that high reliance on EPS performance conditions

may lead management to pursue actions aimed at

increasing short-term EPS rather than enhancing

long-term value creation. Our results are best

interpreted as suggestive given the small sample

size. Nevertheless, they are consistent with

large-sample academic research documenting

similar effects.

» There exists a material disconnect between the key

performance indicators (KPIs) that management

disclose to shareholders and the corresponding

metrics used to incentivise and reward senior

executives. In particular, approximately a third

of our sample displays apparent misalignment

between the non-financial drivers of business value

and the performance metrics used to incentivise and

reward CEOs.

On the one hand these results provide a degree of

reassurance to the extent they confirm the existence of

a statistically and economically significant link between

CEO pay and two measures of periodic value creation

(RI and FCF defined using an all-inclusive approach).

The correlations for RI and FCF are at least as large as

those documented for TSR and EPS using pooled tests;

and in some cases the association is significantly

stronger. Results suggest current CEO pay structures

incentivise and reward important aspects of value

creation even though the specific performance metrics

used in executive contracts are not directly linked with

value creation in many cases.

On the other hand our findings raise cause for concern

given that (i) a large fraction of CEO pay appears

unrelated to periodic value creation and (ii) key

aspects of compensation consistently correlate with

performance metrics such as TSR and EPS growth

whose theoretical link with value creation is fragile.

Collectively, results highlight a worrying disconnect

between CEO compensation and measures of

fundamental value creation to all capital providers,

and therefore raise important questions about the

structure and effectiveness of prevailing compensation

arrangements for UK executives.

19 SUMMARY AND CONCLUSIONSTo shed further light on executive compensation

plan design and the link between CEO pay and value

creation, we analyse compensation and performance

data for the period 2003-2013 using a sample of

30 companies from the FTSE-100 index. Empirical

tests focus on compensation arrangements for

CEOs because (i) they have primary responsibility for

strategic direction and organisational performance,

(ii) CEO pay structures are a good proxy for

executive-level compensation arrangements more

generally, and (iii) CEO pay attracts most attention from

investors, governance activists, and the media.

The analysis seeks evidence on three questions. First,

what is the degree of alignment between alternative

measures of periodic performance? Second, to

what extent is executive compensation aligned with

alternative measures of periodic performance and

in particular with proxies for value creation? Third,

how does the set of performance metrics employed

in executive compensation plans align with the key

performance indicators that drive value at the individual

company level? Key findings relating to these questions

are summarised as follows:

» Consistent with extant academic research and

survey evidence, we find that EPS and TSR are the

most commonly employed performance metrics in

CEO compensation contracts throughout our sample

period. In contrast, value-based metrics such as FCF

and RI are rarely used. (As an aside, our analysis also

highlights the conceptual and practical problems

associated with operationalising FCF, which may

partly explain why this metric has failed to gain

widespread traction as a basis for measuring period

performance);


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