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Excerpts from the Book > Chapter 12

Chapter 12 : Incentive Compensation

Excerpt from Chapter 12

In business, as in many facets of life, incentives play a large role in determining subsequent performance. And since the expectations for future financial performance lie at the heart of expectations investing, it stands to reason that a company's incentive compensation arrangements should concern us as investors. While most investors readily acknowledge the significant interplay between incentive compensation and performance, many fail to appreciate that a company's management incentives can provide important clues about likely upward and downward expectations revisions.

Three issues in particular stand out. First, investors assume that as long as companies offer equity-linked compensation (predominantly employee stock options), managers have the appropriate incentives to generate superior returns—that is, returns that exceed an appropriate benchmark. As we will show, many incentive compensation schemes—including equity-linked schemes—are essentially pay-delivery mechanisms rather than true incentives.

Second, investors believe that employee stock options are the right compensation tool for all levels of management. In fact, options are not the right compensation tools for employees who have little practical control over stock price performance. This group, of course, includes most employees.

Finally, most employee stock option programs provide too much compensation when the stock market is strong and too little when markets are weak. As a result, executives often simply reprice (or reissue) options following a market decline. This situation presents shareholders with an unsatisfactory heads-I-win, tails-you-lose proposition.

In this chapter, we discuss what properly designed performance measures and compensation arrangements look like. The objective of an incentive system is unambiguous—to motivate managers and employees to create value by rewarding them for the value that they create. The best incentive programs encourage managers to deliver results that exceed market expectations. Ill-conceived programs reward mediocrity, and they are often the precursor to disappointing financial results.

Questions Addressed in Chapter 12

To explore incentive compensation issues, Chapter 12 answers the following questions:

  • What are the right questions for an expectations investor to ask when analyzing incentive compensation programs?
  • Why do standard stock option programs miss the pay-for-performance mark in bull and bear markets?
  • How do different methods of granting options—including the fixed-value plan, fixed number plan, and megagrants—help or hinder value creation?
  • How can an expectations investor take advantage of a mismatch between the options grant approach and a company's circumstances?
  • How do indexed options programs better align the interests of managers and shareholders seeking superior returns?

Essential Ideas in Chapter 12

  • Understanding executive and employee incentive compensation programs is essential to improving your chances of anticipating changes in market expectations.
  • Standard executive stock options depart from the pay-for-superior performance ideal because they reward any increase in share price—even when a company lags its competitors or the overall market.
  • Indexed options appropriately reward executives for superior performance in bull and bear markets alike.
  • Appropriate pay plans reward operating unit executives for delivering superior shareholder value added, that is, value above market expectations.


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