STANFORD CLOSER LOOK SERIES

Topics, Issues, and Controversies in Corporate Governance and Leadership

Sensitivity of CEO Wealth to Stock Price: A New Tool for Assessing Pay for Performance
By David F. Larcker and Brian Tayan September 15, 2010 Pay for Performance

In recent years, much attention has been paid to the suitability of CEO compensation among U.S. firms. Of particular concern are whether total compensation packages are too large, whether they encourage excessive risk taking, and whether they are merited given the performance of the company. This last issue is known as pay for performance and gets at the question of how closely compensation is correlated with the results the executive generates. There is considerable debate as to whether pay is actually correlated with performance in U.S. companies, with evidence to support both sides. On the one hand, many elements of the compensation package are explicitly linked to performance targets. For example, the annual bonus is awarded based on an executives ability to achieve objectives that are established at the beginning of the year.1 The size of the bonus directly scales in proportion to the executives success in these areas. Also, CEOs receive a significant portion of their compensation in the form of equity awards (stock options and restricted stock). The value of this compensation is directly tied to share price and, in the case of stock options, has zero value if the stock price is below what it was on the grant date. The structure of these payments indicates that there must be at least some pay for performance.2 On the other hand, there have been a considerable number of large payments made to executives whose companies have not performed particularly well. For example, in 2007, Robert Nardelli (CEO of the Home Depot) received a severance package of $210 million, even though he resigned under pressure from shareholders who were frustrated

with the companys performance during his six-year tenure.3 Richard Fuld (CEO of Lehman Brothers) sold stock awards worth almost $200 million and Angelo Mozilo (CEO of Countrywide) almost $500 million, none of which they were required to repay through clawbacks when their companies collapsed in the financial crisis of 2008.4
Measuring Pay for Performance

In discussing pay for performance, the business media often highlights payments made to an executive in a given year. This measurement, however, is misleading for two reasons: 1) it involves compensation payouts that accrued over a number of years, and 2) it is not framed in terms of the shareholder value created during the executives tenure.5 For this reason, it is more instructive to examine the relation between CEO wealth (measured in terms of equity ownership through stock and options) and stock price returns. One way to make this assessment (and a method favored by academics) is to measure the dollar change in CEO wealth over small percentage changes in the stock price. Based on a sample of 4,000 publicly traded U.S. companies, the average (median) CEO stands to gain roughly $58,000 in wealth for every 1 percent increase in stock price. Among the largest 100 companies, this figure approaches $640,000.6 A potentially more informative method is to consider the change in executive wealth over larger changes in stock price (after all the CEO is hired to do more than increase the stock price by 1 percent). An easy way to do so is to plot the percentage change in the expected value of the CEOs equity portfolio against percentage changes in stock price ranging from -100 percent to 100 percent. The 0
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Sensitivity of CEO Wealth to Stock Price: A New Tool for Assessing Pay for Performance

percentage point on the x-axis is based on CEO wealth at prevailing market prices and the -100 percentage point is where the value of equity goes to zero. By graphing this data and comparing these results to direct competitors or peer firms, observers can better understand the relative risk and reward being offered. Of particular note is the convexity of the payout curve. For example, a manager who is rewarded predominantly in restricted stock or only holds stock will see a change in wealth that is essentially linear (low convexity) and coincides one-for-one with the change in wealth of the average shareholder. By contrast, a manager who is rewarded predominantly in stock options (especially those with tranches of stock options with different exercise prices) will see a change in wealth that has a much steeper payout curve (high convexity) and promises significant wealth for superior performance.7 Payout curves with high convexity may encourage more risk taking, while payout curves with low convexity may encourage less risk taking. This can be good or bad, depending on the strategy of the organization.8 As an example, we can consider the relation between pay and potential performance for a series of direct competitors: Regulated utilities: If the stock price of Southern Company increases by 100 percent, the CEO of the companys Georgia Power division will realize a 235 percent increase in wealth (a ratio of 2.35). By comparison, the ratio at Exelons ComEd division is 1.23. Compensation at Southern Company therefore seems to encourage more risk taking. Under what circumstances is it appropriate for a public utility to engage in risky activities (see Exhibit 2)? Food companies: The CEO of General Mills has convexity in his compensation of 2.98, while the CEO of Kraft has convexity of 1.18. The CEO of General Mills, however, was appointed to the position during the year. While it can be appropriate to use options to help a CEO build wealth in the company at a faster rate, will a more aggressive compensation structure impact company strategy and risk (see Exhibit 3)? Pharmaceutical companies: The CEOs of Johnson & Johnson and Abbott Laboratories have

higher convexity in their compensation (2.26 and 2.13, respectively) than the CEOs of Pfizer and Merck (1.78 and 1.67). Does a diversified healthcare model require more risk taking than a pure-play pharmaceutical model (see Exhibit 4)? While it is difficult for outside observers to determine whether these payout functions are appropriate, this is the type of analysis that the compensation committee can review to make a reasoned assessment of whether compensation contracts are providing appropriate incentives for performance, and gauge their potential to encourage excessive risk taking.9 These are also key inputs for analysts attempting to make a judgment about future cash flows and risks associated with a company.
Why This Matters

1. The current debate on pay for performance is characterized by heated rhetoric with little concrete analysis to inform conclusions. Measuring the relation between change in CEO wealth and shareholder returns is one method shareholders and stakeholders can use to determine whether compensation contracts are appropriate. 2. While it is reasonable for a CEO to increase wealth at a faster rate than shareholders (because executives are asked to make strategic decisions), it is not clear what the ratio of this relationship should be. Should it be 1.5 times, 2.0 times, 2.5 times, etc? In all likelihood, the ratio should be determined in the context of the companys industry, competitive positioning, and risk appetite, as well as the size of the executives equity holdings and tenure.
According to a confidential survey conducted in 2005 by a major HR consulting firm, the top measures used to determine the annual bonus include profit measures (earnings per share, EBITA, net income, operating income, and pretax profit), return measures (return on capital, return on assets, and return on equity), cash flow measures (cash flow, economic value added, and working capital), and other measures (sales growth, customer satisfaction, product/service quality, safety, and employee satisfaction). Typically, there is also a subjective component for individual performance. 2 This assumes that shareholders measure performance in terms of value creation and that executive decisions impact stock prices. 3 Julie Creswell and Michael Barbaro, Home Depot Board Ousts Chief, Saying Goodbye with Big Check, The New York Times, Jan. 4, 2007. 4 Stock sales occurred between 2003 and 2007. Mark Maremont, John Hechinger and Maurice Tamman, Before the Bust, These
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Sensitivity of CEO Wealth to Stock Price: A New Tool for Assessing Pay for Performance

CEOs Took Money off the Table, The Wall Street Journal, Nov. 20, 2008. 5 For example, James Kilts, CEO of Gillette, came under fire for receiving a severance package worth $185 million following the sale of Gillette to Procter & Gamble in 2005. Less noted was the fact that Kilts increased the value of Gillette by over $20 billion during his four-year tenure, delivering annual returns of 14 percent compared with negative 0.6 percent for the S&P 500. Sources: Graef Crystal, Kilts is the Real Winner in P&G Buying Gillette, Bloomberg, Feb. 23, 2005; and calculations by the authors. 6 Includes the fair value of beneficially held stock and options (both vested and unvested). In calculating stock option fair value, remaining terms are reduced by 30 percent to adjust for potential early exercise or termination. Source: Equilar compensation and equity ownership data for fiscal years from June 2008 to May 2009. 7 For simplicity, we use the term convexity to mean the percentage return on the CEOs equity portfolio for a 100 percent change in the stock price. This is taking a bit of liberty with the pure mathematical definition of convexity. 8 Since 2006, companies have had to provide detailed information on each tranche of options held by named executive officers. Previously, options outstanding were pooled together. Disaggregation in the disclosure allows us to precisely plot out the changes in value of each, based on prevailing market prices. 9 Obviously, risk taking can be either good or bad for shareholders. Firms are in business to take appropriate risk and generate the required returns for shareholders. Risk taking is negative when the risk assumed by investment, financing, and operating decisions is excessive in relation to the potential return.

David Larcker is the Morgan Stanley Director of the Center for Leadership Development and Research at the Stanford Graduate School of Business and senior faculty member at the Rock Center for Corporate Governance at Stanford University. Brian Tayan is a researcher with Stanfords Center for Leadership Development and Research. They are coauthors of the books A Real Look at Real World Corporate Governance and Corporate Governance Matters. The authors would like to thank Michelle E. Gutman for research assistance in the preparation of these materials, Christopher Armstrong and Gaizka Ormazabal for help with computations, and Equilar Inc. for providing access to the raw compensation and equity ownership data. The Stanford Closer Look Series is a collection of short case studies that explore topics, issues, and controversies in corporate governance and leadership. The Closer Look Series is published by the Center for Leadership Development and Research at the Stanford Graduate School of Business and the Rock Center for Corporate Governance at Stanford University. For more information, visit: http://www.gsb.stanford.edu/cldr. Copyright 2012 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.

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Sensitivity of CEO Wealth to Stock Price: A New Tool for Assessing Pay for Performance

Exhibit 1 CEO Wealth and Sensitivity to Stock Price Change median

Firm Size Top 100 101 to 500 501 to 1000 1001 to 2000 2001 to 3000 3001 to 4000 1 to 4000 Market Cap ($ thousands) $36,566,000 6,899,000 2,067,000 636,000 175,000 35,000 337,000 Total CEO Pay ($) $11,439,000 6,590,000 4,147,000 2,168,000 1,187,000 623,000 1,615,000 Total CEO Wealth ($) $48,758,000 21,170,000 13,201,000 8,129,000 3,545,000 827,000 5,176,000 Wealth (1% change) 1.26% 1.22% 1.16% 1.09% 1.07% 1.06% 1.10% Wealth (50% change) 67.6% 63.1% 59.7% 55.7% 53.9% 53.8% 55.8% Wealth (100% change) 139% 130% 121% 113% 109% 109% 113%

mean
Firm Size Top 100 101 to 500 501 to 1000 1001 to 2000 2001 to 3000 3001 to 4000 1 to 4000 Market Cap ($ thousands) $60,793,000 8,692,000 2,190,000 707,000 186,000 39,000 2,891,000 Total CEO Pay ($) $13,628,000 8,926,000 5,693,000 3,002,000 1,784,000 947,000 3,387,000 Total CEO Wealth ($) $1,080,493,000 84,962,000 71,194,000 33,841,000 12,825,000 2,602,000 56,622,000 Wealth (1% change) 1.33% 1.29% 1.21% 1.15% 1.12% 1.09% 1.15% Wealth (50% change) 72.6% 71.9% 63.3% 59.6% 58.2% 58.9% 61.1% Wealth (100% change) 151% 169% 130% 122% 119% 122% 128%

Note: Calculations exclude personal wealth outside company stock. Total CEO compensation is the sum of salary, annual bonus, expected value of stock options granted, expected value of restricted stock granted, target value of performance plan grants, and other annual compensation. Calculations for compensation exclude changes in pension. Stock options are valued using the Black-Scholes pricing model, with remaining option term reduced by 30 percent to compensate for potential early exercise or termination and volatility based on previous year actuals. Source: Equilar compensation and equity ownership data for fiscal years from June 2008 to May 2009.

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Sensitivity of CEO Wealth to Stock Price: A New Tool for Assessing Pay for Performance

Exhibit 2 Change in CEO Wealth: Exelon v. Southern Company Exelon v. Southern Company
300% 250% 200% 150% 100% 50% 0% -50% -100% -100% -50% 0% Stock Price Return 50% 100% Shareholders CEO - Southern Co. CEO - Exelon Corp.

Return to Shareholders and CEO

Company Southern Co. Exelon Dominion Resources

Market Cap ($ thousands) 28,659,000 36,587,000 20,835,000

Total CEO Pay ($) 2,246,000 1,236,000 3,275,000

Total CEO Wealth ($) 3,620,000 4,010,000 5,510,000

Wealth (50% change) 110% 60% 50%

Wealth (100% change) 235% 123% 100%

Note: The graph shows the expected change in CEO wealth, given a change in company stock price. While shareholders realize a 1-for-1 change in wealth with stock price, CEO wealth will vary depending on the mix of compensation. Compensation packages that include a heavier allocation of stock options will exhibit a steeper pay off, while those that include a heavier allocation of restricted stock will exhibit a more linear payoff. Calculations exclude personal wealth outside of company stock. Source: Equilar compensation and equity ownership data for fiscal years from June 2008 to May 2009. Includes CEOs of Southern Co Georgia Power, Exelon ComEd, and Dominion Generation.

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Sensitivity of CEO Wealth to Stock Price: A New Tool for Assessing Pay for Performance

Exhibit 3 Change in CEO Wealth: Packaged Food Companies General Mills v. Kraft
300% 250% 200% 150% 100% 50% 0% -50% -100% -100% -50% 0% Stock Price Return 50% 100% Shareholders CEO - General Mills CEO - Kraft

Return to Shareholders and CEO

Company General Mills Campbell Soup Kraft

Market Cap ($ thousands) 16,837,000 13,515,000 39,446,000

Total CEO Pay ($) 10,118,000 9,784,000 16,120,000

Total CEO Wealth ($) 13,710,000 74,240,000 25,870,000

Wealth (50% change) 138% 108% 58%

Wealth (100% change) 298% 223% 118%

Source: Equilar compensation and equity ownership data for fiscal years from June 2008 to May 2009.

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Sensitivity of CEO Wealth to Stock Price: A New Tool for Assessing Pay for Performance

Exhibit 4 Change in CEO Wealth: Pharmaceutical Companies Johnson & Johnson v. Pfizer
300% 250% 200% 150% 100% 50% 0% -50% -100% -100% -50% 0% Stock Price Return 50% 100% Shareholders CEO - Johnson & Johnson CEO - Pfizer

Return to Shareholders and CEO

Company Johnson & Johnson Abbott Labs. Pfizer Merck

Market Cap ($ thousands) 166,002,000 82,807,000 119,417,000 64,271,000

Total CEO Pay ($) 23,023,000 27,977,000 10,378,000 16,291,000

Total CEO Wealth ($) 80,650,000 119,820,000 18,630,000 21,730,000

Wealth (50% change) 106% 100% 82% 78%

Wealth (100% change) 226% 213% 178% 167%

Source: Equilar compensation and equity ownership data for fiscal years from June 2008 to May 2009.

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