Business Day

How to Gauge a C.E.O.’s Value? Hint: It’s Not the Share Price

Fair Game

By GRETCHEN MORGENSON    JUNE 17, 2016

Everybody knows that chief executives receive bounteous pay as a matter of course. In 2015, for example, the median pay for a top corporate executive at 200 large American companies was $19.3 million.

Less discernible, though, is who actually earned their pay the most by increasing the value of the companies they run by a commensurate amount. Such performers are not to be confused with executives who work to propel their company’s stock price. This pursuit can have fleeting benefits and disastrous consequences, as Valeant International, the beleaguered drug company, has shown.

One reason it’s so hard for shareholders to determine a chief executive’s value is that companies’ descriptions of their pay packages are complex. For example, the discussion of General Electric’s compensation practices took up more than 20 pages of its 65-page proxy this year.

Any investor who plows through these pay documents will recognize a common corporate theme: The amounts awarded to the chief executive are aligned with shareholders’ interests because the pay is grounded in the company’s performance.

But companies use a bewildering array of benchmarks in their compensation decisions. These gauges often vary, even within the same industry, making apples-to-apples comparisons difficult and hampering an investor’s ability to determine when an executive is overpaid.

“It is amazing how complicated companies make the proxy and how studiously they avoid the simple informative presentation of relative pay for relative performance,” said Stephen F. O’Byrne, president of Shareholder Value Advisors, a firm specializing in compensation design and performance measurement.

The most common performance metrics used by companies can be problematic. Total shareholder return, according to a recent study by Equilar, a compensation analysis firm in Redwood City, Calif., is the single most popular measure related to pay at big public companies.

Companies love total shareholder return in part because it is easy to calculate. But a company’s stock can rocket even when its operations are being run into the ground. So basing pay on total shareholder return can encourage an executive to manage more for a company’s share price than for its overall health.

“When you look at total shareholder return relative to pay, you’re not looking at the underlying returns of the business,” said Mark Van Clieaf, managing director at MVC Associates International, a consulting firm. “That can take investors down the wrong path.”

A better way to measure whether a C.E.O. has created value at a company is to look at its return on capital over a period of years. This reveals how effectively a company is using its own money to generate profit in its operations.

When you compare these returns to an executive’s compensation, you see where pay is justified and where it isn’t.

I asked Mr. O’Byrne and Mr. Van Clieaf to analyze returns on capital among the top 200 companies whose compensation was reported by The New York Times three weeks ago. The goal was to see how the executive pay at each company stacks up against its corporate performance and highlight which companies are giving away the store to their chief executives and which are getting their money’s worth.

Mr. O’Byrne and Mr. Van Clieaf began by examining each company’s return on capital over the last five years and then comparing it with companies in the same industry. This resulted in a relative return on capital for each corporation.

The experts then compared each company’s C.E.O. pay last year with that of its peers. This produced a relative pay figure that could be set against its relative return on capital over five years. The calculations were adjusted for company size.

Among the top 200 companies, the study concluded that 74 overpaid their chief executives in 2015 based on five years of underperformance in return on capital. The total overpayment last year to the C.E.O.s at these companies, the study found, was $835 million.

Industries with the greatest outsize pay were energy, technology, media, health care and consumer products, the study said.

Companies high on the overpayment list included Salesforce.com, a software company; Vertex Pharmaceuticals; and the Vector Group, a tobacco concern.

All three companies had a return on capital below that of their peers over the last five years, the analysis showed. Nevertheless, the pay received by these company’s chief executives was lush.

For example, at Salesforce.com, return on capital fell 23 percent over the last five years. As a result, Marc Benioff, its chief executive, received almost $31 million more last year than was warranted by the company’s performance against its peers.

Jeffrey M. Leiden of Vertex Pharmaceuticals received $27 million in excess pay based on the company’s negative 35 percent return on capital over the period. And Howard M. Lorber, the head of the Vector Group, was overpaid by $35 million last year when judged on the company’s 4.5 percent decline in return on capital during the previous five years.

Representatives for all of the companies challenged the idea that return on capital was the best way to measure their operations.

Chi Hea Cho, a spokeswoman for Salesforce.com, said that because its business model was based on recurring revenue, return on invested capital was not the right way to measure performance. “We have created a thoughtful executive compensation structure based on total shareholder return, which aligns executives’ interests directly with those of our stockholders, and over the last five years, Salesforce has delivered returns of 111 percent, more than double the S.&P. 500 index.”

Paul Caminiti, a spokesman for the Vector Group, said in a statement: “From 2010 to 2015, Vector’s common stock produced total annualized returns of 21.6 percent, as compared to 12.6 percent for the Standard & Poor’s 500 over the same five-year period.”

A Vertex spokeswoman, Heather Nichols, said in a statement that successful earlier-stage biotech companies were measured largely on research productivity and shareholder returns. “Over the last five years,” she said, “Vertex has delivered three breakthrough medicines to people with serious diseases and a 259 percent total shareholder return.”

The analysis also identified more than 70 companies whose chief executives were delivering outsize returns on capital for fair or even undersize pay.

This group included MasterCard, overseen by Ajaypal Banga, which had a 40 percent premium compared with its peers, and the TJX Companies, the retailer run by Carol Meyrowitz, with a 36 percent excess return on capital.

Philip Morris International, a tobacco company headed by André Calantzopoulos, generated excess return on capital of almost 30 percent compared with its peers.

Gary Lutin, a former investment banker, said it was crucial for investors to assess whether their companies were generating more wealth for management than for shareholders. As overseer of the Shareholder Forum, an independent creator of programs to provide information investors need to make astute decisions, he has convened a workshop to focus investor attention on basic measures of corporate performance that generate long-term shareholder wealth.

“Both investors and corporate directors need to measure performance based on the profits a company generates from its competitively successful production of goods and services,” Mr. Lutin said. “That’s the only real foundation there is for investment value, and for national prosperity.”

A version of this article appears in print on June 19, 2016, on page BU1 of the New York edition with the headline: Gauging the Value of a C.E.O.

© 2016 The New York Times Company