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CEO pay continues to be an extensively discussed topic in the media, in the boardroom, and among investors and proxy advisors. CEO total direct compensation (TDC; base salary + actual bonus paid + grant value of long-term incentives [LTI]) has increased at a moderate pace in recent years — in the 2-6% range for 2011-2016. However, CEO pay accelerated in 2017 at an 11% increase, likely reflecting sustained robust financial and total shareholder return (TSR) performance. Our CEO pay analysis is focused on historical actual TDC, which reflects actual bonuses; this is different from target TDC or target pay opportunity, which uses target bonus and is typically set at the beginning of the year.
As proxies come out in early 2019, we expect 2018 CEO TDC increases may be in the upper single or low double digits based on past pay trends as a result of strong earnings growth and a tight executive labor market. These likely large increases will be further supported by +22% S&P 500 TSR in 2017.
However, given the recent U.S. stock market downturn and a potential global slowdown, 2019 CEO target TDC will likely return to historical, moderate increase levels of flat to low single digits due to economic uncertainty and low TSR (-4% S&P 500 TSR) in 2018. Executives in industries with favorable economic conditions and higher growth will likely see bigger pay increases than those in slow-growth industries.
CEO pay rebounded 31% in 2010 after -9% and -13% decreases during the financial crisis of 2008 and 2009, respectively.Since then, year-over-year pay increases have been moderate —in the 2-6% range —except for the 11% increase in 2017 (Figure 1).
Over the last several years, LTI vehicle use has shifted away from stock options, mostly in favor of performance-based plans. From 2009-2017, performance plan and restricted stock prevalence increased, and stock option prevalence decreased (Figure 2). The rise in performance-based plans can largely be attributed to proxy advisors and some shareholders considering performance share plans, and not stock options, to be performance-based. There could be an uptick in stock option usage in the future given the stock market’s current volatility, especially if a recession were to occur and companies were to struggle to set long-term goals in their performance share plans. We noticed that many companies made stock option grants during the depth of the great recession in early 2009, as goal setting was challenging and stock options provided a direct linkage to share price improvements and an opportunity for significant upside leverage.
CEO pay increases have been supported by strong TSR; in fact, pay increases over the last 7 years have trailed TSR performance by approximately 9% based on the Compound Annual Growth Rate. In every year TSR increased, CEO pay also increased (Figure 3). These increases were not always proportionate: from 2011-2017, each annual pay increase was ≤11%, while the S&P 500 TSR ranged from 1-32%.
There is clear positive correlation between share price performance and CEO pay. In a positive stock price environment, Compensation Committees are often more supportive of CEO pay increases, typically delivered via larger LTI grants. CEO base salaries sometimes only periodically increase (i.e., less than on an annual basis) and typically only comprise a small portion of the executive pay package. Annual actual bonuses, though not as large as the LTI portion, can have a meaningful impact on whether pay increases year-over-year. When a company is having a good year and is exceeding budget goals and investor and analyst expectations, the CEO bonus often pays above target and increases year-over-year (often, the share price also increases as company performance is strong). That said, there will be some years where a CEO’s bonus pays above target when the company exceeded its budgeted goals, while the share price goes down due to stock market volatility or correction and sector rotation (this will likely happen for bonuses paid in early 2019, as 2018 performance was strong for many companies). The opposite can also happen: goals are not met, resulting in lower bonuses, while the stock market goes up.
1) We expect overall 2019 CEO target TDC to be flat to up in the low single digits for many executives in most industries.
a) Our research suggests that CEO pay increases were lower in 2011-2016 (Figure 1); however, strong acceleration occurred in 2017 and possibly in 2018.
b) Aggregate S&P 500 Index year-over-year revenue and earnings per share (EPS) for 2018 are forecasted to increase by 7-9% and 18-20%, respectively (earnings are up significantly in part due to the corporate tax cut; based on data sourced from S&P Capital IQ).
c) EPS forecasts for 2019 are currently showing 9-11% growth over 2018 (S&P Capital IQ), though we suspect this number could be optimistic given economic uncertainty.
d) Slower earnings growth, the media, income equality optics from the CEO pay ratio, and proxy advisor scrutiny will likely exert negative pressure on executive pay.
e) We expect CEO target pay increases in early 2019 to be flat to up in the low single digits due to 2019’s economic uncertainty and low 2018 TSR. Boards will likely become more conservative on pay increases, even though they will continue to offer market-competitive pay to help retain executives in what still appears to be a competitive labor market.
2) In certain high growth industries — such as biotechnology or information technology — executives may experience continued faster growth in total compensation in 2019, while executives in slow-growth industries might see smaller or no increases.
The above projections do not account for major market shocks (e.g., geopolitical or trade uncertainty, dramatic changes in the economic environment, significant modifications to the Federal Reserve’s interest rate policies, or significant drops in the overall stock market).
The CEO pay analysis consists of S&P 500 companies led by CEOs with a ≥3-year tenure. Pay data includes base salaries and bonuses paid for each year as well as the reported grant date fair value of LTI awards. Our analysis of consistent incumbent CEOs was designed to highlight true changes in CEO compensation (as opposed to changes driven by new hires or internal promotions, which typically involves ramped-up pay over a period of 2-3 years).
Our methodology used year-over-year CEO actual pay and was based on the accounting value of LTI as reported in proxy summary compensation tables. These amounts are more akin to pay opportunity and are different from realizable pay, which includes in-the-money value of stock options, ending period value of restricted stock, and estimated value of performance shares. Our past research has strongly correlated realizable pay and TSR performance. While we have shown there is a positive correlation between CEO annual pay increases and TSR performance, we are confident the correlation is not as high as that between realizable pay and TSR increases.
Directors face many challenges when serving on a public company’s Board of Directors Compensation Committee. One of the most difficult tasks facing theCompensation Committee annually is the review and approval of the performance metrics and performance targets developed by management for inclusion in annual and long-term incentive plans. Typically, the performance targets submitted by management for Committee review are the by-products of the company’s annual strategic planning and budgeting processes. The performance targets embedded in the company’s plans are usually derived from and reflective of the expected levels of performance found in the company’s annual business plan. In addition, management will validate its business and performance targets by analyzing the company’s historical performance results as well as the benchmarked performance results of key competitor companies.
Companies deploy a range of performance metrics in measuring performance in their incentive plans, attempting to earn an acceptable quantity and quality of earnings before allowing management to participate in the earnings stream with incentive compensation awards. In recent years in our role as management consultants, we have found more companies using various “return” metrics in their annual plans. We refer to return metrics as inclusive of such measures as return on capital employed, return on invested capital, return on assets, return on equity (extensive use at banks) and return on shareholders equity. These metrics are important for numerous reasons, as return measures establish how well management has used the capital resources deployed in the business. As an investor in a public company, we are more inclined to invest in a company with the ability to generate a high return on invested capital that will hopefully yield superior long-term shareholder returns.
The thesis of this opinion article is that companies can develop more meaningful return performance targets by better understanding the details of its WACC before setting a return performance target. Simply stated, a company’s return on capital performance target will be more relevant if in fact the return shows that the level of performance to be achieved must equal or exceed the company’s estimated cost of capital.
What is WACC, and why is it important? WACC is an internal calculation of a company’s cost of capital. There are several ways that one can estimate a company’s WACC – such calculations can be performed on either a market basis or a book value basis. The book value approach can be used by direct reference to the company’s income statement and balance sheet. The market value approach uses a company’s reported market value of public equity and the market value of the company’s long-term debt. In the following paragraphs, we will use the market value approach. Also, it is important to note that each company will have its estimated WACC which will vary over time. Many variables influenceWACC, including interest rates and the cost of debt, stock price volatility as measured by Beta, company tax rates, industry sector dynamics and trends, and investors’ appetitive for risk. 
The basic formula for calculating a company’s WACC is:
WACC = (R/V * Ke) + (D/V) * Kd * (1-Tax Rate)
R = market value of company equity (market capitalization)
V = total market value of equity and debt
Ke = cost of equity
D = market value of debt
Kd = long-term cost of debt
Tax Rate = corporate tax rate
The following example of a hypothetical company will illustrate the calculation of WACC with the following set of assumptions:
Total shares outstanding 2,000,000
Share price $50.00
Market value of long-term debt (bonds) $25,000,000
Risk-free rate (10-year Treasury) 2.50%
Cost of debt (rate of return on company bonds) 5.50%
Corporate tax rate 21.00%
Investor risk premium 6.00%
Companystock Beta 1.10
Based upon the WACC formula above and the assumptions noted, we can calculate the hypothetical company’s WACC in five steps.
Determine the Market Value of Equity – the first step is to calculate the company’s current equity market value. This is calculated by multiplying the total number of shares outstanding times the current share price. In our example, the market value of our hypothetical company is $100,000,000 (2,000,000X $50.00 = $100,000,000).
Determine the Market Value of Debt -- the second step is to determine the value of the company’s long-term debt, which can be found on the balance sheet. Our company’s long-term debt is $25,000,000.
Calculate the Cost of Equity – determining the cost of equity requires the use of the Capital Asset Pricing Model (CAPM), a financial model developed in the late 1950’s which assesses the relationship for investors of evaluating risk and likely returns. The CAPM considers three inputs: the rate of return on a current long-term government instrument such as a 10-year U.S.treasury bond representing a risk less rate of return; the Beta for the company’s stock price which considers the volatility of the stock price in relation to general movements of the market; and an estimated risk premium (i.e., the additional return an investor expects to receive in order to invest in a security above the rate of a risk less return available from a government bond). Generally speaking, a typical risk premium is 6.00% for a U.S. security, although we have seen some financial experts use risk premiums ranging from 5.00% to 9.00% in selected applications. In our example, we have used a 2.50% rate of return for a 10-year treasury, assumed a risk premium of 6.00%, and have further assumed a stock Beta of 1.10. With these three inputs, we calculate our example company to have a cost of equity of 9.10% (2.50% + 6.00 X 1.10 =9.10%).
Calculate the Cost of Debt – our next step is to determine the cost of our company debt, which in our example is assumed to be 5.50% (the rate of return expected by the company’s long-term bond holders). This figure must be adjusted for the tax-deductibility of interest expense, which is calculated to 1.00 minus the company’s tax rate of 21%. Our example results in a cost of debt equal to 4.35% ((5.50% X (1.00 - .21)) = 4.35%
Apply the WACC Formula – Based upon these 4 steps and calculations, we can then estimate our WACC by application of the WACC formula with this fifth step.
WACC = (R/V * Ke) + (D/V) * Kd * (1 – Tax Rate)
WACC = ($100,000,000/$125,000,000 ($100,000,000 +$25,000,000=$125,000,000) * 9.10%) + ($25,000,000/$125,000,000) * 5.50% (1.00 –21%)
WACC = (80% * 9.10%) + (20% * 4.35%)
WACC = 8.15%
Estimating a company’s WACC is a thoughtful and beneficial exercise in corporate finance, and it has many applications that management can employ in testing the reasonableness of many investment opportunities. It is our judgment that the WACC precept has a meaningful application in the design and implementation of incentive compensation plans and that determining a company’s WACC is an important step in testing the validity of a company’s return targets for annual and long-term incentives. Unless a company’s return performance target exceeds its estimated cost of capital, directors serving on the Board’s compensation committee should be reluctant to approve management’s proposed return on investment performance target.
General questions about this Viewpoint can be directed to John Ellerman at email@example.com.
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