Home Fundamental Analysis Explained Executive Compensation: How Much Is Too Much?

1/10/2012 2:37:52 AM

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Is the company in which you hold stock being run for the benefit of shareholders, or merely to line the pockets of its management? The proxy statement contains the information you need to find out how and under what conditions management is being paid. We’ll show you how to analyze it. (For background reading, see Pay Attention To The Proxy Statement .)

What Investors Should Look For

When examining a proxy statement, investors should look for the following:

Base Pay

In the proxy. the company will list the base salary for each key member of the management team, such as the chief executive officer (CEO), chief financial officer (CFO), legal counsel, director of sales and other divisional heads. Take that dollar number and compare it to what other executives received in the past. Old proxies are available at www.sec.gov.

You can also look near the last page of the proxy statement for a chart on how executive compensation matches up against other industry players or a broader index, such as the Standard & Poor’s 500 Index (S&P 500). If that is not available, peruse the proxies of other major players in the same industry and see if the pay scale is comparable.

Stock Options

Stock options. if used the right way, are a terrific way to inspire management to maximize shareholder value. This is particularly true if the current market price is well below the value at which management can exercise his or her stock options and convert to common stock. In other words, under those conditions, the ambitious executive will find ways to enhance shareholder value and get the stock price up.

However, there is a downside to options compensation. For example, management is awarded a significant options grant that is barely out of the money. meaning if the stock price goes up a little, management will be able to exercise options, convert them to common stock and sell the shares to reap a quick windfall. Or, in a more extreme case, the executives may benefit from blatant options backdating. (To learn more about options backdating, read The Dangers Of Options Backdating .)

What is excessive or what features of options compensation should investors be looking for? Again, a comparison against executives both internally at the company and externally among industry players will determine what’s acceptable. An example of a typical analysis of executive compensation is found in the following comparison of pay structure at Home Depot Inc. (NYSE:HD ) and Lowe’s Companies Inc.(NYSE:LOW ):

Proxy Date Company CFO Base Salary Bonus Options Exercise Price 4/14/2006Home DepotCarol Tome$694,231$820,00065,000$37.704/14/2006Lowe’sRobert Hull Jr.$450,000$900,00026,500$58.35

HD stock opened in 2005 at $42.17, and closed the year at $40. The pricing of those options hardly gives Tome an incentive to do anything besides show up to work and protect her job.

Lowe’s started the 2005 fiscal year trading just above $58 and closed the year at $63.52. Hull’s option grant is consistent with Tome’s. In fact, their base pay, bonus and stock options are fairly similar.

Both executives are receiving similar amounts of compensation. But the more important finding is that both insiders lack financial incentive to enhance shareholder value, particularly with their options so close to the exercise price. (For related reading, see The Controversy Over Option Compensation and A New Approach To Equity Compensation .)

Perks

It is customary for some senior executives at large companies to receive reimbursement for relocation expenses, pay bonuses and the use of company-owned transportation, such as a corporate jet. But there are (and should be) some limits to those perks.

For example, the more than $100,000 of company expenses that Wal-Mart’s (NYSE:WMT ) chief executive, Lee Scott, racked up in 2005 to cover things, such as physicals, personal airplane travel and home security systems might be considered excessive to some investors — but it’s up to you to decide based on what other executives in similar positions receive, whether these perks could contribute to shareholder value and good old common sense.

Other interesting perks officers have been called on over the past few years include:

Driving lessons for the executive’s children Personal nannies An interest in the company’s operating profits Personal automobiles Elaborate parties for spouses or non-executives

Perks paid out to executives at small companies should be subject to even greater scrutiny because this type of greed is more likely to bankrupt smaller companies or contribute to annual deficits. (For more insight on executive perks, see Footnotes: Start Reading The Fine Print .)

Length of Service Contracts

The proxy will reveal when an executive’s employment contract is set to expire. While on the one hand it may be in the company’s best interest to have a short-term contract so that it’s on the hook for a smaller amount financially, a longer term contract is preferred. Longer term deals suggest that both parties (the company and the employee) are looking to partner up for a long period of time to work toward a common goal.

Side Deals

Investors should be on the lookout for any side deal or third-party transactions. Specifically, they should seek out any deals that could present a conflict of interests.

For example, Worldcom’s 2002 proxy statement revealed that more than $400,000 was paid out to a company to provide air travel to Worldcom employees. The company that received payment was owned in part by Worldcom’s chairman, Bert Roberts.

While one cannot prove that Roberts took advantage of this situation, investors may assume that Roberts’ company might not have given Worldcom the most advantageous pricing. Third-party transactions aren’t always a sign that management is taking advantage, but they should garner additional investor scrutiny.

Golden Parachutes

Upon their departure from a company, well-heeled executives tend to have severance packages worth millions. In many cases, such package deals are payable regardless of whether the company meets its financial objectives or is even profitable. It is also customary for some executives to receive health benefits upon retirement for years of service, or other reasonable perks. But some executives truly do receive too much at the expense of shareholders.

For example the severance package awarded to Michael Ovitz, former president of The Walt Disney Co. (NYSE:DIS ), totaled more than $140 million, which was about 10% of Disney’s total annual net income. Or consider the $40 million that chief executive Jill Barad received from Mattel Inc. (NYSE:MAT ). She was fired because the company’s stock had dropped more than 50%.

This is not to say that some companies, particularly the larger players in the industry with well-known and respected leaders, can’t have lofty severance packages. However, when the dollar amounts total in the millions and come at the expense of the current year’s earnings, investors should take notice. (For related reading, see The Wacky World Of M&As .)