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Basing executive compensation on stock price creates a dangerous motivation

05 January 2007

 

Home Depot CEO Robert Nardelli stepped down from his post of six years due to months of concern about his handling of a 2006 shareholder meeting, his compensation, and company stock performance (chart).  After his resignation he was awarded a severance package worth $210 million, which has sparked new debates over executive compensation.  This article does not deal with the severance package, but instead focuses on the compensation debate that led to Nardelli's ouster.

 

In July 2006, Maria Bartiromo of CNBC interviewed Nardelli and questioned him on several topics including the basis for his compensation, which was tied to corporate earnings and not company stock.  During Nardelli's tenure, Home Depot's earnings per share rose 150% and the company grew extensively, but the stock price lost 5.6%.  Bartiromo pressed Nardelli on his and the Home Depot board's decision to tie his compensation to the more favorable metric: profits.  Since investors typically make their money from the stock price, she argued, Nardelli was being favorably compensated for stock performance that harmed Home Depot's investors.

 

Bartiromo's point is common but flawed.  The purpose of compensation - whether it is for a CEO or a janitor - is intended to influence employee motivation.  Company compensation structures benefit the company when they motivate employees to better serve the company.  Basing executive pay on stock price is harmful to the company because it generates a harmful motivation.

 

Stock prices are not tied to the value of a company.  They are influenced by the public's perception of the (future) value of a company.  Those perceptions are often in line with the actual value of the company but not always.  Consider Enron.  Enron's stock was soaring up to the moment that the public learned that the company was bankrupt, and all of Wall Street's "experts" were fooled.  Perception was far from reality.  The stock price followed the perception.  It would be wrong for an executive to be overpaid because the company's stock was overvalued, as was the case with Enron.  Conversely, it would be wrong for an executive to be underpaid because the company's stock was undervalued by the market.

 

Using stock price as the metric for determining executive compensation creates a motivation for the executive to focus on improving the perception of the company's value and not necessarily on increasing the actual value of the company.  If improving perception is the easier course for the executive - say through needless advertising or "cooking the books" - than actually improving value, then the executive may channel his energies toward gimmicks that affect perception and - by definition - mislead investors.

 

Admittedly, the Enron catastrophe involved more than a crisis of motivation, but companies will benefit by basing executive compensation on something that executives can influence directly while improving the health of the company: profits.  Better regulatory systems can be (should be?) enacted to improve the accuracy of reported profits but they are less able to control stock price.  Part of an investor's risk stems from the randomness - or dare I say fickleness - of the market.  Forcing executives to share in that risk invites dangerous scheming.