As companies file their annual proxy statements with the U.S. Securities and Exchange Commission (SEC) this spring, a new study by Rice University and Cornell University shows just how S&P 500 companies have tied CEO compensation to performance. The study found large variations in the choice of performance measures, and the researchers said that companies tend to choose measures that are informative of CEO actions.
"On average, firms rely mostly on accounting-based performance measures, among which they put heavier weights on income measures, sales and accounting returns," said David De Angelis, an assistant professor of finance at Rice's Jones Graduate School of Business." Our findings are in line with predictions from optimal contracting theories: Firms with complex activities and large growth opportunities tend to tie a larger fraction of the awards to market-based measures rather than to accounting-based measures."
De Angelis co-authored the paper with Yaniv Grinstein, an associate professor of finance at Cornell's Johnson Graduate School of Management. The paper is forthcoming in the Review of Finance.
The impetus for the study was the SEC's December 2006 ruling requiring enhanced disclosure on how firms tie CEO compensation to performance. The authors used this newly available data to study the terms of performance-based awards in CEO compensation contracts in companies listed on the S&P 500, the stock index consisting of the largest and most prominent U.S. companies. The sample included 494 firms that belonged to the S&P 500 as of December 2007. For each firm they studied the respective fiscal year 2007 proxy statement section related to CEO compensation.
In general, the authors found that companies pre-specified the CEO's performance goals over several performance measures. On average, 79 percent of the estimated value of performance-based awards is based on accounting-performance measures, 13 percent is based on stock-performance measures and 8 percent is based on nonfinancial measures.
The authors found that larger firms and firms with larger growth opportunities tend to rely more heavily on market-based measures, and firms that are more mature tend to rely more heavily on accounting-based measures. Sales are used by firms with larger growth opportunities, and accounting returns are used more heavily by more mature firms with fewer growth opportunities. The researchers also found that firms in similar sectors tend to adopt similar performance measures.
Their findings related to firm characteristics and performance measures suggest that firms tend to choose performance measures that are more informative of CEO actions.
"In growth firms, where CEO optimal actions are improving long-term growth opportunities, end-of-year accounting performance measures are likely to be less informative of optimal CEO actions," the authors said. "For these firms, stock price performance, which captures investors' perception regarding firms' long-term growth opportunities, is a more informative measure."
Among accounting measures, the study found that growth firms tend to rely on sales-growth measures, which again capture CEO actions associated with growth. In contrast, in mature firms, where the CEO's focus is on maximizing value from existing operations, end-of-year accounting performance measures are more informative of CEO actions.
Two interesting findings from the study require further examination, the authors said. "First, a large portion of CEO awards is given at the discretion of the board. How exactly this portion of the awards is determined is an interesting topic for future research. Second, we find that CEO shareholdings have little association with the level of market-based awards in the CEO contract. This result is puzzling because we expect CEO shareholdings to act as a substitute to the market-based awards. We believe that further investigation of this result is another fruitful area for future research."
The recent trend of $1 salaries among high-profile CEOs such as Facebook's Mark Zuckerberg or Hewlett-Packard's Meg Whitman might indicate that CEO shareholdings is an important consideration in compensation decisions. De Angelis said that restricting the salary to $1 could send a positive signal showing the CEO believes in the company and, thus, is an opportunity to boost the company's stock price. "These CEOs are likely to own a large stake in the firm, so the incentives coming from the compensation are rather small compared with the incentives associated with their holdings," De Angelis said. "This $1 salary tack could send a positive signal to the market, meaning the stock price might increase and potentially earn the CEO even more through their holdings."
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