Executive Pay that Works for Shareholders and Companies Like Milli Vanilli in 1990, Total Shareholder Return (TSR) is currently all the rage in executive compensation plans. And, like Milli Vanilli, as entertaining as TSR is to some, it may prove to be a less than stellar performer for most. Of course, unlike the disgraced pop-stars, TSR is unlikely to disappear from view any time soon.
What is TSR?
It is the growth or shrinkage in stock price plus any dividends paid to shareholders. For many shareholders, this is the single most important measurement of how a stock performs against both expectations and peers. It is important to remember that TSR is a result of actions, not the driver of actions. Results are fantastic because they align with accountability. Drivers are critical because they are what lead to results. As a standalone executive compensation metric TSR is good, but its much stronger when combined with other metrics.
Given its ubiquitous use by investors, it is not a shock that it has become the “go to” metric for long-term Pay for Performance (P4P) programs. Say on Pay has lead to an explosion of P4P programs and TSR has quickly become a darling of the consulting crowd. TSR has real value as a metric. But, it may prove to be a less than an ideal goal or modifier of compensation. And, once you include time as an element, you have the ingredients for either a great program or a disaster.
Understanding Metrics and Goals
Metrics are the things you measure. Goals are the triggers or numbers associated with the metric. In some specific cases, the metric and the goal can be the same item. This is true in the case of a Change in Control. Goals can either be thresholds or modifiers. A threshold goal is an on/off switch. A modifier can increase or decrease the amount originally targeted for payout. Any metric can be structured to serve either goal purpose, but some work better than others in either role.
When companies use TSR as a modifier, they generally use a Relative-TSR (R-TSR) metric (your TSR compared to a peer group). This requires a careful and honest selection of peers. Once you have your peers you must determine where your company fits into the group today and where it should fit over the life of an award. Your compensation philosophy and structure should help decide the target award level. With this as a foundation, your modifiers will define a scale of how much more or less (if any) than the target will be received based on your ranking within the peer group. Since R-TSR simply measures your company’s success by how it performs compared to your peers, you pay huge rewards even if you are the only company to stagger onto the beach after a terrible market shipwreck. You may end up paying out at the top tier while your shareholders simmer and your employees are laid off.
TSR as a Threshold Goal
Now consider TSR or R-TSR as a threshold goal. You may have a very good idea of the absolute TSR that is acceptable to your shareholders. Or, you may know generally where you need to fit into the pack to be considered a good investment. You can use this knowledge to use TSR as a threshold goal. For example: 3 year absolute TSR must be at least 12% or R-TSR must be above the 65thpercentile in our peer group. Obviously, these are cleaner and easier goals to communicate and operate, but alone they deliver no value to your executives. It is unlikely you want to use an all or nothing switch for your executives’ long-term incentives.
When using TSR or R-TSR as a threshold, you should combine it with another metric linked to a modifier goal. Common metrics for this purpose include revenue, profit and EBITDA. But, the great thing about your modifier metric and goals is that you can focus your executives on the aspects of your business that drive TSR. Combining TSR and internal metrics allows you to meet the needs of your shareholders. Like a lip-syncing pop star, TSR may prove to be less than you expected. Before you finalize your decisions on metrics consider a more nuanced approach to your executive compensation programs.
TIP: If you are using TSR or some other performance metric in your programs you might want to take a look at the following document on how to better communicate these programs.
This was originally posted on the PayScale Compensation Today blog.