Executive Compensation and Deconstructing TSR Metric

by ERI Salary Surveys 30. November 2011 14:22

 

The prevalent use of Total Shareholder Return (TSR) as a payout or vesting trigger for long-term executive compensation elements begs the question, "How is TSR derived?" To do this, let’s start by deconstructing TSR and review how it is calculated:

TSR = ((Stock Price end – Stock Price begin) + Dividends) / Stock Price begin

TSR is essentially “shareholder’s cash flows,” that is, net change in stock price plus the dividends paid during a fixed period and expressed as a percentage change of the beginning stock price for that period. For shareholders, TSR is a measure they are interested in tracking and meaningful metric. Since it is expressed as a percentage change and can easily be indexed with comparable companies, TSR enables shareholders to make industry benchmark comparisons. As the business mantra is to align executives to shareholders interests, companies use TSR metric provide a line of sight for shareholders to evaluate performance.

Now let’s deconstruct TSR further and look at each component: stock price and dividends. The stock price is typically the key driver of TSR value fluctuations, whereas dividends will typically have little effect since they are relatively “stable.” The main reasons why dividends tend be a more stable part of the calculation are 1) dividend payout patterns are information signaling to the market regarding the long-term prospects of a company and affect the company’s stock price, and 2) companies are not likely to reduce or eliminate dividend payments in an attempt to avoid negative market response. A company could have a negative stock price performance over a certain period yet still generate a positive total shareholder return if dividends paid outweigh the stock price fall (logically possible yet highly unlikely).

Up to this point, it is apparent why many companies use TSR. As investors, shareholders need a “relative” measure to gauge past success of investment choices and TSR does it for them. (Note: TSR is not predictive of future performance.) At this juncture, there is an outstanding nagging issue to the prevalent use of TSR, especially since many companies use it as the single metric for long-term incentive plans. Companies need to consider alignment with the long-term interests not only of shareholders, but also customers and employees. For a more holistic alignment that can potentially result in expanded access to financial markets, customer loyalty, and employee engagement should be combined with TSR as well as other relevant measures that align the long-term interests of customers and employees.

Some obstacles to adding these additional measures may be related to how efficiently and reliably they can be reported. TSR can “easily” be reported and validated by multiple third party sources. Can customer and employee related measures be reported and validated in the same way without disclosing business or trade secrets or perhaps being internally manipulated to a company’s advantage?  Executive compensation pay for performance will continue to garner the attention of diverse constituents, and we can expect new best practices to evolve.  Business practitioners will have to evaluate these developments in terms of relevancy and application to their own organization’s needs. 

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