Executive Compensation: Demystifying Total Shareholder Return (TSR)

Summary

In this episode of 'Inside America's Boardrooms,' TK Kirsten discusses Total Shareholder Return (TSR) as a key metric for executive compensation with Tom McNeil of Meridian Compensation Partners. They delve into the differences between absolute and relative TSR, exploring the pros and cons of each. Relative TSR compares a company’s performance to its peers, while absolute TSR measures stock price performance against predefined goals. The discussion also touches on the use of hybrid models, combining both metrics to ensure fair rewards while aligning executive performance with shareholder interests.

Takeaways

• 😀 Relative TSR compares a company's stock performance to a peer group over a three-year period, while absolute TSR compares performance against pre-established stock price goals.
• 😀 Relative TSR is the most commonly used metric in executive compensation plans, especially in industries with clear peer groups.
• 😀 Absolute TSR is less common but is seen as a stronger alignment with shareholders because it focuses on the company’s own stock performance.
• 😀 A major advantage of relative TSR is that it doesn’t require goal-setting, but it can sometimes result in payouts even when overall company performance is poor.
• 😀 A key disadvantage of relative TSR is that it can reward executives for being the best among a poor-performing group, which doesn’t always reflect strong leadership or company success.
• 😀 Absolute TSR aligns compensation with shareholders by setting performance goals, but its major challenge is predicting future stock prices, which are subject to external factors.
• 😀 Both relative and absolute TSR are subject to extrinsic market factors, such as economic conditions, that executives have little control over, which is a common criticism of both metrics.
• 😀 Compensation committees are increasingly adopting a hybrid approach by using absolute TSR as a cap or modifier for relative TSR to avoid overcompensating executives in poor market conditions.
• 😀 The debate between using relative vs. absolute TSR often centers around balancing reward for executives' performance with broader market realities and shareholder interests.
• 😀 The use of TSR metrics is a crucial aspect of aligning executive pay with company performance and shareholder value, making it a key topic in boardroom discussions around executive compensation.

Q & A

What is Total Shareholder Return (TSR)?

Total Shareholder Return (TSR) is a measure of a company's stock price performance over time, typically factoring in both stock price appreciation and dividends. TSR can be used to evaluate how well a company has performed in terms of creating value for its shareholders.

What is the difference between absolute and relative TSR?

Absolute TSR measures a company's stock price performance against pre-established goals or growth rates, while relative TSR compares a company's performance to a peer group of companies. The key difference is that absolute TSR focuses solely on the company's performance, while relative TSR evaluates it in the context of other companies.

Why is relative TSR more commonly used in executive compensation plans?

Relative TSR is more commonly used because it aligns executive performance with the performance of other companies, without requiring the setting of specific goals. This makes it easier to measure and evaluate, especially in homogeneous industries where peer companies are readily identifiable.

What are the advantages of using relative TSR as a metric in executive compensation?

Relative TSR has strong alignment with shareholders' interests, as it compares the company's performance against a peer group. Additionally, it doesn't require goal-setting, making it simpler to implement. It’s also widely favored by shareholders and proxy advisors as it measures executive performance in relation to competitors.

What are the drawbacks of using relative TSR in executive compensation?

One drawback is that it requires the selection of a relevant peer group, which may not always be possible in diverse sectors. Additionally, it can lead to situations where executives are rewarded despite poor company performance if they outperform a weak peer group. Moreover, some argue that relative TSR provides poor line of sight, as executives cannot control the performance of other companies.

How does absolute TSR provide better alignment with shareholders?

Absolute TSR aligns better with shareholders because it measures the company's own performance against its pre-established goals. This removes external factors (like peer performance) from the equation, providing a more direct link between executive compensation and shareholder returns.

What is a major challenge with using absolute TSR in executive compensation?

The major challenge with absolute TSR is goal-setting. Predicting the company’s stock price growth over a three-year period can be difficult, especially when stock prices are influenced by external factors outside of management's control. This makes setting realistic, meaningful goals more complex.

Can a company combine absolute and relative TSR in its executive compensation plan?

Yes, many companies use a hybrid approach, combining both absolute and relative TSR. This allows for a balanced evaluation, where relative TSR assesses performance against peers, while absolute TSR ensures that executives are not rewarded for poor performance if the company’s stock price declines, even if they outperform their peers.

What is a common mechanism used to cap payouts when using relative TSR and absolute TSR together?

A common mechanism is to use absolute TSR as a cap or modifier for relative TSR. If a company’s stock price is negative over the performance period, even if it outperforms its peers, the payout may be capped at target levels. This ensures executives are not rewarded excessively in situations where shareholder value declines.

Why is there debate about whether management should be rewarded during a market downturn?

The debate arises because while executives may make excellent decisions during tough times, leading to cost-saving measures or other positive actions, shareholders still face losses if the market or sector as a whole performs poorly. Some argue that good management should still be rewarded, while others believe no rewards are justified if the company's stock value drops.