Would a mandate ever be established that would demand that CEOs and other top executives receive only a $1/year salary? Should these executives be forced into receiving a large part of their compensation from stock-based compensations only? Peter Whoriskey and the shareholders of Home Depot would furiously contest that the top executives need to be compensated in a manner that takes into account stock as they are a representative base of how well a company is doing within its market. Stocks are a standard measurement for the market and market analysts to measure the health of a company and it seems logical that the compensation of top executives should reflect the health of the company. Top executives at top companies who have thousands of shareholders and millions of stakeholders depending on them often are able to throw the company into risky scenarios that could see the company fail. The problem is that in many cases, failing CEOs still take home millions due to their contract clauses while the stakeholders are left to pick up the scraps from the damage left behind. However, upon closer observation, stock-based compensation might not entirely solve the issue as well. Rodger Martin, a contributor to the Harvard Business Review Blog, is convinced that focusing on ratios on a company’s balance sheet, Returns on Invested Capital (ROIC), Earnings Per Share (EPS), and Market Share are the factors that executive salaries should be dependent on.
Unearned contracts can be seen everywhere nowadays as people continually attempt to estimate the worth of an individual without seeing their productivity for the company. When Home Depot hired Robert Nardelli in 2000 as their CEO, they offered him a contract offer worth over $40 million/year guaranteed. Nardelli came to the company with an impressive CV at GE at the request of Kenneth Langone who was serving on both the boards of GE and Home Depot. Despite his impressive CV, Nardelli had no retail experience whatsoever having spent his entire career in the diversified machinery industry. His lack in knowhow came to light as his tenure saw Home Depot’s stock drop 8% and their market value drop $19 billion. (Khurana,1) Kenneth Langone had assumed and expected that Nardelli’s success at GE would help him do very well at Home Depot although his entire industry experience lay within the confines of GE. (Khurana,6-8) Could there have been any other outcome for Nardelli? Bowie discusses an idea from Kantian ethics called “self-defeating nature of immoral actions” that might help shed some light on this common corporate fallacy.(Bowie,2) Bowie believes that there is a moral line called a maxim (aka. principle) that can be tested to see whether a principle is good or bad. This idea can be explained through the simple principle of cutting a line. I might think that I might be justified in cutting the line, but if everyone was to cut the line and think that it was okay as a universal maxim then the principle of a line would not exist.(Bowie, 2-4) In the same way, if we are to compensate every single executive based on what they have done in the past then there is no failsafe for potential damage the individual could do to the firm. The hiring process currently depends on the adequate judgment of potential hires and assumptions which, for the most part, do not tell an accurate story of an individual. For example, in 1983 John Sculley was hired to become Apples CEO based on his work at Pepsi. Sculley fired Steve Jobs and went on to lose Apple market share with projects and investments that posted large losses. In 1993 Apple fired Sculley after paying a hefty compensation package and rehired Jobs as the CEO five years later. Today we know that Jobs’ known experience within the industry has helped Apple become one of the most innovative companies on the planet. Society has created this maxim that says that any (relevant or irrelevant to the industry) experience and achievements in the past should automatically bestow executives with hefty guaranteed compensations. Imagine making this a universal principle; everyone who has done something of note in any industry will be hired as an executive although their understanding of the industry they are being hired for is lacking. If the executive fails and gets fired, the companies would lose a lot of money which will, eventually, be transferred to the stakeholders. What would happen if a company hires three experienced executives from other industries and ends up firing all of them? Shouldn’t there be some clauses that ensure that the executive compensation package does not reward more than what the individual has contributed? By this reasoning, Bowie would say there needs to be clauses in all contracts because there is no chance the principle can be validated especially considering how destructive it would be to the company and stakeholders. Stock based compensation would make sure that the person hired is accountable for their performance because their salary is directly tied to how well the company’s stock is doing ,forcing the executive to work harder to ensure the company’s doing well. However, although Stock-based compensation is touted as a solution to the executive salary problem, it might not be the most ideal.
Rodger Martin in his blog, “Scrap Stock-Based Compensation and Go Back to Principles”, counters the notion of incorporating stock-based compensation as a viable solution to the problem. Martin believes that company executives need to be compensated based on the company’s ROIC, EPS, and market share. In order to understand Martin’s argument, first we must understand why stock-based compensation will just not work. Martin believes that the best way to evaluate an executive is by measuring the growth of the company through factors that they can affect. Conversely, stock-based compensation is entirely based on the value of the company’s stock which is “the markets consensus of expectations on how well your company will do”. This means that the company might be doing well financially but have a stock price that does not adequately reflect that and vice verca because stocks are based on future expectations. There is no part that the executives of a company can play to increase the stock of the company so why compensate them on a factor that they cannot control? This base argument is the reason why Martin calls for companies to ditch the stock compensation model and look to something new that the executive has a hand in affecting and would adequately measure their contribution to the company.
Martin pinpoints ROIC, EPS, and the company’s market share as adequate measurements for the performance of top-level executives. These three measures are not derived by some assumption but are real measurements of a company’s well-being and profitability. ROIC is a measurement that is used to see how much the company is making off each dollar it invests in. For a company, ideally the ratio will be larger than 1 and the higher the number, especially when compared with its competitors, the better. Executives have the ability to affect this ratio by making sure that the company is making worthwhile investments that create more dollar value for the investment; if that is not the case, the executives are not doing their jobs. EPS might sound like a stock-based factor but in reality it is not. It does not base itself off the stock price but rather the amount of stocks that are given out to stockholders. Since giving out stocks (for money) is a type of loan (as stockholders expect some kind of return), EPS makes sure that a company can monitor how much value it is creating from each stock that it has given out. This is important because the company wants to ensure that they are making a profit off the stockholders’ investments. Making a loss on the investments would imply that the company is declining in its net income which would indicate bad executive management. Market share is the last factor that Martin insists that is looked at when evaluating an executive and might be the most obvious of all the factors. Market share is simply put as the amount of the industry dollars that your firm controls compared to all the dollars circulating in the industry. For those who are not giants in an industry, any increase in market share is a plus while the giants of an industry would consider growth, or even a maintaining of distance with competitors, as an achievement. Companies know where they currently stand and where they want to get to and it’s up to the upper executives to pave the road. ROIC, EPS, and Market Share are all real factors that evaluate the performance of a company and in turn the performance of whoever is running it; its executives. As such, tying compensation packages on how well the company does according to these factors will help improve executive productivity, reduce the grandiose executive salaries, and create fairness regarding how the upper echelon is treated.
Through Home Depot, we see exuberant compensation packages that go out to executives that do not reflect the ability or the performance that they put into the position. Judging on past experience alone will not get the best candidate into the position. Peter Whoriskey would claim that the only solution to this problem would be by incorporating stock-based compensations to force the executives to work harder knowing that their compensation was tied directly to the company’s performance. This is an idea that many are embracing today but, in the opinion of Rodger Martin, it is not necessarily the most complete idea. Yes, executives need to be monitored by tying their compensation to the health of the company, but stock-based compensation does not do that. With stock being determined by outside assumption of future worth, there is no way that an executive’s productivity can determine the stock price. Since they do not have any direct effect on the stock price, executives might be pressured to influence those outside forces that do and make a large personal profit off false predictions which would hurt the company in the long run. However, the company’s ROIC, EPS, and market share are all measurements that adequately show the health of the company and will most likely push executives to do much better because they know that their performance is directly tied into the performance of the company and the compensation they receive.
Bowie, Norman: A Kantian approach to business ethics
Khurana, Rakesh: AFL-CLO: Office of Investment and Home Depot