Misguided Management: Why Stock Options Aren’t the Problem

by JT McGee

Managers of publicly-traded companies make a whole lot of money. In 2011, the average CEO of the 500 largest companies took home $10.5 million, much of that being valuable stock options and appreciation in unvested stock options.

Large pay opens the doors to criticism. If Wall Streeters made the median American income, Occupy Wall Street would have never come to exist. That’s just the way things work.

Welcome to the United States of America.

Why Stock Options Aren’t the Problem

Stock options are seen as a way to encourage short-term thinking that does not correspond to long-term success. Stock options are probably like heroin – heroin makes you feel good until you realize you’re quickly on the path towards homelessness fed by addiction. The good decision in the short-term (shooting up) leads to a poor long-term future.

While stock options might encourage short-term decision making, they do encourage management to maximize shareholder value. If management owns a significant part of the company, then they have incentive for that company to be as valuable as it can be.

Hence, stock options help align the interests of management with the shareholders. In an ideal world, management would then have incentive to make decisions that would lead to a higher share price.

The Real Problem: Salary Mathematics

The real problem with management salaries isn’t how managers are compensated. Rather, the problem is in deciding how much management should be compensated and by what measure we should evaluate the work of a skilled manager.

Many managers are paid based on metrics that destroy shareholder value. You’ll often hear managers reference revenue and profit growth over their tenure. While revenue and profit growth are traits of a good business, these numbers are meaningless without perspective.

Consider this: a CEO of a trucking company decides to allocate capital to new trucks rather than repurchase shares of his or her undervalued company. The trucks provide a 7% annual return on capital. The stock provides a 20% return on capital, as it trades at a price-to-earnings multiple of 5.

If the CEO is compensated based on total revenue and profit growth, he or she made the right decision for his or her compensation package. However, insofar as enriching shareholders, the CEO made a terrible decision, forgoing a 20% return for a 7% return on investment capital. These are the kind of mistakes you would expect of Dave Ramsey, not of a corporate executive with an MBA from Harvard.

Limits on Stock Performance

There are really only three limits to stock performance: the PE ratio, the potential size of the firm in the future, or the return on the businesses’ retained earnings.

It’s one thing to buy a company at a PE ratio of 8 – that’s a 12.5% annual return on the stock in the form of earnings. It’s another thing to buy a company at a PE ratio of 8 that sticks its earnings in a bank account yielding .001% per year.

Likewise, it’s great to own a company that can grow to eventually become a $1 billion business from a $10 million business. However, if the company earns only 1% on its reinvested earnings, you’ll need to wait a few generations to ever see that growth.

Management’s sole interest should be to generate the highest possible return on earnings. If that means buying undervalued stock instead of expanding the business’s operations, so be it. Unfortunately, management is rarely compensated for sound capital allocation decisions. Rather, management is rewarded based on metrics that have nothing to do with shareholder interests, such as revenue and profit growth, and thus managers make poor decisions with a business’s retained earnings.

Shareholders and the public at large pay the price for incetivized incompetence. Stock options are just an often misunderstood scapegoat, one which dilutes the value of the discussion on finding and rewarding quality managers – managers who think like investors.

{ 3 comments… read them below or add one }

Thomas S. Moore November 5, 2012 at 09:49

Never saw it put this way before. But I would still have to think that in the short term is management is increasing whats good for his/her compensation the stock prices would have to increase as well. I mean usually you are giving stocks and are only allow to sell them if the hit a certain target price. I agree that the options are not the problem and many of these C level employee are really overpaid.

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JT McGee November 5, 2012 at 13:00

I’m not necessarily sure that all C-level employees are overpaid. CEO salaries are probably much more easily justified than other C-level compensation. I’m usually most interested in who the CFO is. CFOs are definitely overpaid if they’re not getting in the way of bad capital allocation decisions. Then again, being a CFO is easier than ever – just refinance all that high interest debt during Bernanke’s boom!

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krantcents November 5, 2012 at 20:50

I never had a problem with executives earning based on performance. After all, I was one of them and earned performance based bonuses etc. The real problem is many executives are paid very well regardless of performance.

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