Is Executive Compensation Tied to Relative Performance?

Recall from Result 18.9 that compensation contracts should be designed to eliminate

as much extraneous risk as possible. One way to eliminate extraneous risk is with a

relative performance contract, which determines executive compensation according

to how well the executive’s firm performs relative to some benchmark such as the

performance of the firm’s competitors. The relative performance contract would thus

have the desired feature of reducing the effect of risk elements that affect all industry

participants, which probably are not within the CEO’s control, while rewarding the

executive only when he or she beats the relevant competition.

By far, the largest fraction of performance-based pay comes from stock options.

Although these options could, in theory, be indexed to industry stock price movements,

in practice they are not, implying that relative performance does not have a major

effect on pay. For some firms, however, annual bonuses are tied to relative perfor-

mance. Murphy (1999) reports that in a 1997 survey of 177 large U.S. firms by the

consulting firm Towers Perrin, 21 percent of the 125 industrial companies tie their

annual bonuses to their firm’s performance relative to their industry peers. The sur-

vey indicates that the percentage of financial firms that do this is 57 percent, and the

percentage of utilities that base their executive’s bonuses on relative performance is

42 percent.

The fact that few industrial firms have embraced relative performance-based pay

may reflect the fact that these contracts can adversely affect the competitive environ-

ment within an industry. The disadvantage of this type of contract is its undesirable

side effect of providing the CEO with an incentive to take actions that reduce its com-

petitor’s profits, even if doing so doesn’t help his or her own firm. For example, a firm

that utilizes a relative performance contract may compete more aggressively for mar-

ket share since the costs imposed on competitors from being aggressive improve the

CEO’s compensation, even if the gain in market share does not improve profits. The

consequences are that if all industry participants instituted relative performance con-

tracts of this type, industry competition would be more aggressive and profits would

likely be lower for all firms in the industry. Perhaps this is one reason we do not observe

explicit relative performance compensation contracts.

Result 18.10

Relative performance contracts, which reward managers for performing better than eitherthe entire market or, alternatively, the firms in their industry, have an advantage and a dis-advantage.

•	The advantage is that the contracts eliminate the effect of some of the risks that arebeyond the manager’s control.

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•	The disadvantage is that the contracts may cause firms to compete too aggressively,which would reduce industry profits.

Stock-Based versus Earnings-Based Performance Pay

Performance-based compensation contracts come in two distinct forms: stock-based

compensation contracts,which include executive stock options (see Chapter 8) and

other contracts that provide an executive with a payoff tied directly to the firm’s share

price, and earnings or cash flow-based compensation contracts, based on nonmarket

variables like earnings, cash flow, and adjusted cash flow numbers such as Stern Stew-

TM

art’s Economic Value Added (EVA), discussed in Chapter 10.

Stock-Based Compensation.The advantage of stock-based compensation is that it

motivates the manager to improve stock prices, which is exactly what shareholders

would like the manager to do. However, there also are disadvantages associated with

stock-based compensation which lead us to believe that earnings or cash flow-based

compensation might be preferred in many cases.

The first disadvantage of stock-based compensation is that stock prices change from

day to day for reasons outside the control of top managers (for example, changes in

interest rates). The second disadvantage is that stock prices move because of changes

in expectations as well as realizations. This second disadvantage is illustrated in Exam-

ple 18.6.

Example 18.6:Using Stock Returns to Evaluate Management Quality

Consider two CEOs, Ben and Alex, who are hired at the same time to manage competing

toy companies.Investors initially have an extremely favorable opinion of Ben and expect his

company, the Coy Toy Company, to do well.However, investors initially are extremely skep-

tical about Alex’s qualifications and the prospects of his company, Toyco.How will the stock

market react over the next few years if the two toy companies do equally well?

Answer:If both companies do equally well, Coy Toy will have performed worse than

expected and Toyco will have performed better than expected.Hence, Toyco’s stock price

will perform much better, merely due to the improved opinion of Toyco’s future.

In general, companies would like to compensate managers based on how much they

contribute to shareholder value. As Example 18.6 illustrates, however, stock prices

reflect how well the managers did relative to expectations. Hence, with stock-based

compensation plans, managers are penalized when investors have favorable expecta-

tions and are helped when investors have unfavorable expectations.

Earnings-Based Compensation.The principal advantage of compensating managers

on the basis of earnings and cash flows is that the numbers are generally available for

the individual business units of a firm as well as for nontraded companies that cannot

easily base compensation on an observable stock price. However, compensating man-

agers based on earnings and cash flows also has its drawbacks. First, it is difficult to

calculate the cash flow number that would be appropriate to use for evaluating per-

formance. For example, one cannot simply base the executive’s compensation on total

earnings or cash flows because this will provide an incentive to increase the scaleof

the corporation’s operations, even if doing so requires the firm to take on negative net

present value projects. Hence, there is a need to adjust the cash flows for the amount

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650Part VIncentives, Information, and Corporate Control

of capital employed, which is likely to change from period to period. In addition, both

cash flow and earnings numbers that can be pulled easily from a firm’s income

statements are accounting numbers which include various adjustments for inventory

valuation methods, pension fund liabilities, and so forth, and might not provide a very

reliable measure of a firm’s performance.

Value-Based Management.The idea that managers in individual business units

should be compensated according to the contribution of their units to overall firm value

attracted substantial attention in the 1990s and has generated large revenues for con-

sultants. Consultants like Marakon Associates, Stern Stewart, McKinsey, and Boston

Consulting Group/Holt have developed what they call value-based managementmeth-

ods to transform accounting cash flows to economic cash flows so that they more accu-

rately measure the economic cash flows that are most useful in compensating man-

agers.¹⁸Each of the preceding methods share the insight that managers create value by

making positive net present value choices and reward managers for making such

choices. As discussed in Chapter 10, these methods calculate the value created by a par-

ticular business unit by subtracting a charge for the amount of capital employed from

the cash flows of each unit. The methods can differ in the way that cash flows and the

cost of capital are calculated.

The advantage of a value-based management compensation method over stock-

based compensation methods is summarized below:

Result 18.11

Stock-based compensation has the advantage that it motivates managers to improve shareprices. However, stock prices change for reasons outside of a manager’s control and onlypartially reflect the efforts of a manager who heads an individual business unit in a diver-sified corporation. Acash flow-based compensation plan that appropriately adjusts for cap-ital costs may provide the best method for motivating managers in these cases.

Compensation Issues, Mergers, and Divestitures

The discussion in the last subsection suggests that although stock-based compensation con-

tracts might prove useful for motivating top management, they are less useful as a device

for motivating the head of a business unit who has little influence on the firm’s overall

profitability. For example, the efforts of Compaq’s CEO are better reflected in the price

of the company’s stock than the efforts of his counterpart in the personal computer divi-

sion of a multidivisional firm such as IBM. This puts IBM at a comparative disadvantage

to Compaq in motivating the managers in its PC group because their compensation can-

not be structured as easily to reflect the results of their efforts. This is especially true when

the economic cash flows of the individual business units are hard to measure.

Spin-Offs and Carve Outs.Schipper and Smith (1986) and Aron (1991), among

others, have argued that these motivational issues are one reason firms sometimes

choose to spin offa division—transforming the division into a new company by

distributing shares of the new company to the firm’s existing shareholders—or carve

outa division—that is, do an IPO of the division, making it an independent operating

firm. Announcements of spin-offs and carve outs usually lead to a favorable reaction

in stock prices. In a sample of 93 spin-off announcements between 1963 and 1981,

Schipper and Smith found that stock prices increased 2.84 percent, on average, when

the spin-offs were announced.

¹⁸Chapter

10 discusses the products offered by various consultants.

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Cusatis, Miles, and Woolridge (1994) described the case of Quaker Oats spinning

off Fisher Price, its toy subsidiary in 1991. Fisher Price reported losses of $37.3 mil-

lion and $33.6 million in the two years before the spin-off, but in its first two years as

a public company, Fisher Price showed profits of $17.3 million and $41.3 million,

respectively. The authors attributed at least part of the strong operating performance of

the new company to the financial incentives of the officers and directors, 14 of whom

held 6.2 percent of the outstanding shares as of March 23, 1993. While these individ-

uals might have held stock in Quaker Oats prior to the spin-off, the connection between

their efforts and the resulting payoff would have been much less direct, so the incen-

tive effects would have been substantially reduced.

Mergers.Divestitures of corporate divisions—achieved via spin-offs, carve outs, or

direct sales to a third party—are the opposite of mergers, which combine separate firms

into a single entity. Indeed, many divestitures often reverse prior conglomerate mergers,

which occur when the combining entities are in unrelated lines of business. The dis-

cussion above implies that such mergers may adversely affect managerial incentives.

Specifically, the CEO of an independent firm with publicly traded stock is likely to

find his or her incentives to maximize shareholder value weakens when the firm

becomes a division of a much larger entity, particularly when that entity combines many

disparate businesses.

Chapter 20 describes various operating synergies that offset the incentive problems

that arise from combining firms in a merger. In cases where both the synergies and the

incentive problems are large, a partial takeover may be warranted. In a partial takeover,

the acquiring firm buys a controlling interest in the target, possibly to take advantage

of synergies, but it leaves a number of shares outstanding on the market. These remain-

ing shares make it possible to compensate the partially owned subsidiary’s management

more efficiently. Partial takeovers of this kind are common in many countries outside

the United States but are less common within the United States.

We summarize the discussion here as follows:

Result 18.12

Improved management incentives provide one motivation for corporate spin-offs anddivestitures. Similarly, conglomerate mergers may weaken the incentives of executives atthe various divisions.

18.6	Summary and Conclusions

This chapter examined why the financial decisions of man-of major corporations. One innovation was the greater useagers often deviate from those predicted by the theoriesof executive stock options and other contracts contingentpresented in Parts III and IV. We first described the type ofon stock price, which link the pay of top executivesconflicts that are likely to arise between the interests ofdirectly to the performance of their companies’stock. An-shareholders and managers. Some of these conflicts ariseother change was the increased use of debt financing,because managers simply prefer more pleasant to lesswhich creates pressure on managers to improve productiv-pleasant tasks. Other conflicts arise because managersity while reducing their ability to initiate wasteful invest-have an incentive to steer their firms in directions that en-ments. Athird change was the greater participation of in-hance their own career opportunities and limit their risks.stitutional investors. Afinal change was a more activeFinally, top executives are likely to develop more of a loy-takeover market, which made it more difficult for under-alty to their employees, suppliers, and customers, whomperforming managers to keep control of their firms.they interact with on a day-to-day basis, than to their in-We should emphasize that the agency models of man-vestors, with whom they are in much less frequent contact.agement behavior are somewhat cynical and do not en-

Since the 1980s, a number of changes have reducedtirely capture management behavior. Brennan (1994) andthese incentive problems, thus improving the profitabilityothers have expressed concern that the way we teach

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652Part VIncentives, Information, and Corporate Control

students about self-interested managers may, in fact, bemanagers to their employees. Most managers will try toself-fulfilling, convincing students that self-interested be-keep a sick or disabled employee on the payroll—at thehavior is the appropriate norm. Indeed, Frank, Gilovich,expense of the firm’s shareholders—out of concern for theand Regan (1993) reviewed experiments which impliedemployee and his or her family rather than because of anythat undergraduate students trained as economists arepersonal benefit to the manager. Clearly, there are notablemuch less likely than other students to cooperate for theexceptions, but we have no reason to suspect that manage-common good.ment incentives are anything but noble. However, when

The fact that the interests of managers and shareholdersevaluating financial decisions, we must take into accountdifferdoesn’t mean that managers are purely self-interestedthat these incentives are not always aligned with those ofor greedy. Indeed, the greatest source of management-shareholders.

shareholder conflict probably arises from the loyalty of

Key Concepts

Result	18.1:	Management interests are likely to deviate	•The benefits of discretion are
		from shareholder interests in a number of	greater in more uncertain
		ways. The extent of this deviation is	environments.
		likely to be related to the amount of time	•The costs of discretion are greater
		the managers have spent on the job and	when the interests of managers and
		the number of shares they own.	shareholders do not coincide.
Result	18.2:	Firms with concentrated ownership are
			Therefore, we might expect to find more
		likely to be better monitoredand thus
			concentrated ownership and more
		better managed. However, shareholders
			managerial discretion in firms facing
		who take large equity stakes may be
			more uncertain environments.
		inadequately diversified. All shareholders
			Result 18.6:Shareholders prefer a higher leverage
		benefit from better management;
			ratio than that preferred by management.
		however, the costs of having a less
			As a result, firms that are more strongly
		diversified portfolio are borne only by
			influenced by shareholders have higher
		the large shareholders. Because of the
			leverage ratios.
		cost of bearing firm-specific risk,
		ownership is likely to be less concentrated	Result 18.7:Alarge debt obligation limits
		than it would be if management efficiency	management’s ability to use corporate
		were the only considerations.	resources in ways that do not benefit
			investors.
Result	18.3:	Entrepreneurs may obtain a better price
		for their shares if they commit to holding	Result 18.8:Afirm’s debt level is a determinant of
		a larger fraction of the firm’s outstanding	how much the firm will invest in the
		shares. The entrepreneur’s incentives to	future and it can be used to move the
		hold shares is higher for those firms with	firm toward investing the appropriate
		the largest incentives to “consume on the	amount. In general, however, capital
		job.” The incentive to hold shares is also	structure cannot by itself induce
		related to risk aversion.	managers to invest optimally.
Result	18.4:	Managers may prefer investments that	Result 18.9:Agency problems partly arise because of
		enhance their own human capital and	imperfect information and risk aversion.
		minimize risk. This implies that:	Agency costs thus can be reduced by
			improving the flow of information and
		•Managers may prefer larger, more
			by reducing risk. To minimize the risk
		diversified firms.
			borne by managers, optimal
		•Managers may prefer investments
			compensation contracts should eliminate
		that pay off more quickly than those
			as much extraneous risk (or risk
		that would maximize the value of
			unrelated to the manager’s efforts) as
		their shares.
			possible.
Result	18.5:	Allowing management discretion has	Result 18.10:Relative performance contracts, which
		benefits as well as costs.	reward managers for performing better

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653

	than either the entire market or,	prices change for reasons outside of a
	alternatively, the firms in their industry,	manager’s control and only partially
	have an advantage and a disadvantage.	reflect the efforts of a manager who
		heads an individual business unit in a
	•The advantage is that the contracts
		diversified corporation. Acash flow-
	eliminate the effect of some of the
		based compensation plan that
	risks that are beyond the manager’s
		appropriately adjusts for capital costs
	control.
		may provide the best method for
	•The disadvantage is that the
		motivating managers in these cases.
	contracts may cause firms to
		Result 18.12:Improved management incentives provide
	compete too aggressively, which
		one motivation for corporate spin-offs
	would reduce industry profits.
		and carve-outs. Similarly, conglomerate
Result 18.11:	Stock-based compensation has the	mergers may weaken the incentives of
	advantage that it motivates managers to	executives at the various divisions.
	improve share prices. However, stock

Key Terms

agency costs645	principal-agent relationship643
agency problem643	principals643
agents643	proxy fights631
carve out650	relative performance contract648
closed-end mutual funds636	spin-off650
open-end mutual funds636	value-based management650

Exercises

18.1.	Discuss why managers might tend to want their	operating decisions, but they do control financing
	organizations to grow.	decisions. In firm 3, the board has very little
18.2.	Discuss the factors that determine whether firms are	control over either investment, operating, or
	likely to have large ownership concentrations.	financing decisions. Describe how debt ratios are
		likely to differ in the three firms.
18.3.	John Jacobs, the CEO of High Tech Industries,
	owns 51 percent of the shares of his $50 million	18.5.As a Washington policy analyst, you are asked to
	company. The firm is starting a new project that	comment on a proposed law that would make it
	requires $25 million in new equity capital. Jacobs	more difficult for large outside shareholders to
	is considering two ways to fund the project. The	extract private benefits from the partial control they
	first is to issue $25 million in new equity. The	can exert over management. How would such a law
	second is to form a partially owned subsidiary of	affect the incentives of outside shareholders to
	High Tech, which would be called Super Tech,	monitor management?
	and have the subsidiary issue the equity. Under	18.6.You are a member of the compensation committee
	the second proposal, Super Tech would be 55	of the board of directors for both Chrysler and
	percent owned by High Tech and 45 percent	Chevron. How should the compensation contracts
	owned by new shareholders. Describe how the	for the CEOs of these two companies differ?
	incentives of the managers of the new business	18.7.The tendency of firms to use stock-based
	and John Jacobs are likely to be affected by the	compensation is higher for firms with higher
	two proposals.	market-to-book ratios. Provide two explanations for
18.4.	Consider three similar firms that differ only in the	this empirical observation.
	extent to which they are controlled by their boards	18.8.Cybertex’s management currently owns 1 percent
	of directors. In firm 1, the board has complete	of the firm’s outstanding shares. The firm is
	control of the investment decisions, operating	currently financed with 50 percent debt and 50
	decisions, and financing choices. In firm 2, the	percent equity but is planning to increase its
	board is unable to monitor investment and	leverage ratio to 80 percent debt by borrowing and

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654Part VIncentives, Information, and Corporate Control

using the funds to repurchase shares. Management18.9.Suppose that you are designing the compensation

has decided not to participate in the repurchase socontract for the Chicago Bulls’new coach. Two

their percentage ownership of the firm willmain alternatives are possible. In (a) you will

increase.design his bonus based on the total number of wins

Explain how managers’investment incentivesduring the season and the team’s success during

are likely to change after the recapitalization.the playoffs and will ignore any specific decisions

Specifically, discuss their incentives to take:made by the coach. In (b) you will consider the

specific measures taken by the coach and, perhaps

•Negative NPVprojects that benefit them

with the help of independent outside experts, will

personally.

base the compensation on the quality of those

•Risky projects.

decisions but will ignore the number of wins

•Long-term projects that take more than 10during the season. Explain the advantages and

years to provide an adequate return to capital.disadvantages of the two compensation contracts.

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Smith, Clifford W., Jr., and Ross L. Watts. “The

Investment Opportunity Set and Corporate

Financing, Dividend, and Compensation Policies.”

Journal of Financial Economics32 (December

1992), pp. 263–92.

Stulz, René. “Managerial Discretion and Optimal

Financing Policies.” Journal of Financial Economics

26 (1990), pp. 3–27.

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Reaction to Short-Term Executive Compensation

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Economics7, nos. 1–3 (1985), pp. 131–44.

Grinblatt1324Titman: Financial	V. Incentives, Information,	19. The Information	© The McGraw1324Hill
Markets and Corporate	and Corporate Control	Conveyed by Financial	Companies, 2002
Strategy, Second Edition		Decisions

CHAPTER

The Information Conveyed

19

by Financial Decisions

Learning Objectives

After reading this chapter you should be able to:

1.Understand how financial decisions are affected by managers who are better

informed than outside shareholders about firm values.

2.Identify situations in which managers have an incentive to distort accounting

information.

3.Explain how financial decisions about the firm’s dividend choice, capital

structure, and real investments affect stock prices.

4.Interpret the empirical evidence about the reaction of stock prices to various

financing and investing decisions.

On July 10, 1984, ITTannounced a 64 percent cut in its quarterly dividend from

$0.69 to $0.25 per share. Rand Araskog, CEO of ITT, said that the directors

approved the dividend cut to save $232 million, enabling the firm to continue to fund

its investment in high-technology products and services. The market greeted this

announcement with a 32 percent drop in the price of ITTstock: from $31 to $21¹8

per share, implying a reduction in shareholder value of about $1 billion.¹

The magnitude of the decline in ITT’s stock price, described in the chapter’s open-

ing vignette, is certainly unusual. However, stock prices often move 10 to 15 per-

cent when firms announce changes in their investment, dividend, or financing choices,

implying that decisions like these convey information to investors which causes them

to re-evaluate, and thus revalue, the firm.

This chapter provides a framework that will help you to decipher the messages con-

veyed by financial decisions and to understand how information considerations affect

financial decisions. The discussion in this chapter is based on the premise that top

¹See Woolridge and Ghosh (1985) for more discussion on this particular case.

656

Grinblatt1326Titman: Financial	V. Incentives, Information,	19. The Information	© The McGraw1326Hill
Markets and Corporate	and Corporate Control	Conveyed by Financial	Companies, 2002
Strategy, Second Edition		Decisions

Chapter 19

The Information Conveyed by Financial Decisions

657

managers have proprietary information that enables them to derive more accurate inter-

nal valuations of their companies than the investor valuations determined in the mar-

ket. In other words, managers may have information, which cannot be directly dis-

closed, about whether the firm’s stock is either undervalued or overvalued.

Managers may not be able to disclose their information to the firm’s stockholders

for a variety of reasons:

•	The information may be valuable to the firm’s competitors.
•	Firms run the risk of being sued by investors if they make forecasts that laterturn out to be inaccurate.
••	Managers may prefer not to disclose unfavorable information. The information may be difficult to quantify or substantiate.

If direct disclosures provide imperfect and incomplete information, then investors

will incorporate indirect evidence into their evaluations. In particular, investors will

attempt to decipher the information content of observable management decisions. These

information-revealing decisions, or signals, might include decisions related to the firm’s

capital expenditures, financing choices, dividends, and stock splits, as well as man-

agers’decisions to acquire or sell shares for their personal account. For example, an

increase in company shareholdings by IBM’s top executives might signal that man-

agement is optimistic about the firm’s prospects. In many instances, an indirect signal

of this type can provide more credible information than a direct disclosure. As it is

often said, “Actions speak louder than words.”

It is natural to assume that managers take the market’s expected reaction into

account when making major decisions. This is especially true when the ability of man-

agers to keep their jobs, maintain their autonomy, and increase their pay depends, in

part, on the performance of their firm’s stock. If managers have a strong incentive to

increase the current stock prices of their firms, they will bias their decisions toward

actions that reveal the most favorable information to investors. As we will demonstrate,

these actions will not, in general, maximize the intrinsic(or long-term) value of the

firm. In particular, managers may sometimes make value reducing decisions because

they convey favorable information.

An important lesson of this chapter is that a distinction must be made between

management decisions that createvalue and decisions that simply signal or convey

favorable information to shareholders. In many cases, value creating decisions signal

unfavorable information and result in stock price declines, and value destroying deci-

sions signal favorable information and result in stock price increases. For example,

ITT’s decision to cut its dividend would be considered value creating if the cash sav-

ings were used for positive net present value investments. However, as this chapter dis-

cusses, the dividend cut might signal unfavorable information about the firm’s ability

to generate cash from its existing operations.

If bad decisions sometimes convey favorable information, one must be careful

when interpreting stock price reactions to corporate announcements. For example, a

company might think that its shareholders prefer higher dividends because its stock

price always reacts favorably when a dividend increase is announced. However, as

shown later in the chapter, stock prices can respond favorably to a dividend increase

because the increase conveys favorable information, even when most shareholders actu-

ally prefer the lower dividend.

Grinblatt1328Titman: Financial	V. Incentives, Information,	19. The Information	© The McGraw1328Hill
Markets and Corporate	and Corporate Control	Conveyed by Financial	Companies, 2002
Strategy, Second Edition		Decisions

658Part VIncentives, Information, and Corporate Control