Stock Picking by the CEO's Paycheck

Mary Thompson,|Reporter, CNBC

The numbers are eye-popping. Millions, sometimes tens of millions — even hundreds of million of dollars in salary, stock and benefits — are paid to chief executives of American corporations.

At first blush, that kind of money may look excessive, but you'll find plenty of people who say it isn't.  So if you are a shareholder and you hear the CEO of a company whose stock you own was paid $40 million dollars last year, should you care if it's fair?

If it isn't, it should raise questions about the company board of directors, the ones who decided the pay. Have they approved a plan that has the CEO's or the company's best interests in mind?  If it favors the CEO, the board isn't working in the best interests of you, the shareholder.

But how can you tell?

Determining whether CEO pay is justifiable isn't as easy as looking at how much money you made, or lost, in the stock of the company that CEO runs, according to a panel of experts we spoke with.

There are a lot of different variables that go into a CEO's salary, so you need to know what the board wanted the CEO to do, whether he or she delivered, and whether it was better or worse than his or her peers.

Because of rules introduced by the Securities and Exchange Commission last year, that information is easier to find than it once was, meaning investors can decide for themselves if they think a CEO's pay is reasonable.

Information about an executive's pay can be found in a company's proxy statement, in the Compensation Discussion and Analysis (CD&A) section. If you do not have a hard copy of the proxy, you can go to the and look for a company's DEF 14A form, which is another name for the proxy.

To help you navigate the technical language and pages and pages of descriptions that make up these CD&As, we asked five people from different walks of the corporate and investing world to tell us five things they focus on in the CD&A to determine whether or not an executive's pay is fair.  

Aligning Pay With Company Performance

Denny Hightower, former CEO of Europe Online Networks, and a former Disney executive, said looking at how a CEO's pay aligns with company performance is very important.

Hightower is currently a director, and member of the compensation committee for the pizza delivery chain Domino's. He has also chaired the compensation committee at Gillette, and served on the boards of TJX Companies, and Northwest Airlines.

"If I were looking at it as an outside investor, I think I would be very attuned to how the cash and equity portions of the pay align first and foremost with company performance," said Hightower.  To do this,  he said to look at what the company said it was going to do that year, and how well it did it.  This will show investors if the strategy was executed.  Then move down the chain to the CEO.  The CD&A should contain information about the specific targets the board set for the CEO in the past year.

Hightower said when investors are looking at these targets, they should try to determine if they were easy or "stretch" goals for the executive.  Third, see if the peer group the board's chosen to compare the CEO's pay to is appropriate.  The board, he said, should be keeping the peer group fresh and appropriate. 

Fourth, Hightower notes it's important to keep in mind the length of a CEO's tenure when trying to figure out if his or her pay was appropriate. 

"To get the right person, there will be sign-on bonuses, equity awards and other incentives for a new CEO that are not performance driven, so know where the CEO is in the spectrum," he said.

Finally, Hightower notes the incentives a board does put in place for a CEO should be those that reward the executive for making decisions that are good for the company, its customers and the communities in which it firm operates.

Measure Performance

Measure Performance

"What you want to do in reviewing the CD&A is to see if there is any meat behind the alignment of an executives pay for performance", says Eleanor Bloxham, founder and chief executive of the Value Alliance Company and the Corporate Governance Alliance.

By this she means what performance measures the board uses, how they are aligned with pay and why these measures (be they earnings growth, revenue growth or relative performance versus peers) are important. 

Second, like Hightower, Bloxham said investors should look at how pay is tied to strategic goals the firm has outlined in the CD&A.  Third, check if the pay is protected from down cycles in the industry.  Bloxham said there should be no adjustments to protect pay if a firm's industry hits a downcycle, nor should there be adjustments for bad events or regular repricing of stock options.  Bloxham recommended investors also look closely at the severance a CEO would receive, or pay he or she would get if there was a change of control at the company. 

"It's important to understand what the incentive might be to sell the company at a low price" she said, something that would not be in the best interest of shareholders.

Lastly, Bloxham advised that investors take a look at the increases in CEO pay versus the firm's employees. The number for the employees can be found in the salary and benefits line on a company's income statement.  This will give investors an idea of whether the CEO's pay is accelerating at a faster pace than the employees.

Compare Across Peer Group

For Jack Dolmat-Connell, president and CEO of DolmatConnell& Partners, a Waltham, Massachusetts-based compensaton consulting firm, the peer group is the place to start. 

"You want to see that it is the same size," he said.  This means making sure the companies in the peer group have a revenue base and market capitalization similar to that of the company whose stock an investor owns.

Dolmat-Connell also said investors should make sure CEO pay is being measured against other CEOs who run like-sized companies, and not companies that are much bigger. Comparing a CEO's pay to a peer group of larger firms could be the board stacking the deck. That is because they don't want their CEO's pay to be at the top of the peer group for fear it could attract unwanted attention.  Because CEOs of bigger companies usually get paid more, the board could give a good sized payout to the chief of a smaller firm, without coming under fire because the peer comparison would put their pay in the middle of the group.

Second, check and see how the company performed versus the peer group. 

"It takes a little bit of digging," he said, "but its gives you some strong measures to determine if your CEO's pay is merited." 

He recommended looking at a company's one-year and three-year return against the peer group.  The one-year return will let you know if short term incentives like salary increases and bonuses are fair, while the three-year return will show investors if longer term rewards like stock options are appropriate.

Dolmat-Connell also looks at the level of executive and director ownership in a company.  He said those with higher ownership tend to perform better. And by ownership, Dolmat-Connell means how many real shares those executives own, so exclude their stock options in this calculation.

Fourth, he checks out the bonus metrics a board uses -- what does the board use to tie executive pay to the elements that drive shareholder value? Then he goes a step further -- if the board says the goals were to increase net income and revenue by 10 percent in the last year, he looks at whether those targets exceed or lag what was delivered by the company's peers.

"The last thing to look at are the long term incentive vehicles," he said.

Dolmat-Connell said stock options are a better way of rewarding a CEO for increasing shareholder value than restricted shares.  That is because restricted shares are given as long as an executive stays a certain amount of time. With stock options, the executive only benefits if the stock rises to levels above the options exercise price. 

"If you have a high concentration of time-based restricted stock, the company probably isn't expected to perform that well, or isn't performing well," he said.

What is Variable Pay Linked To?

What is Variable Pay Linked To?

"You need to look and see if there is a sufficient amount of total pay that is at risk" said Charlie Tharp, executive vice president for policy at the Center On Executive Compensation. "That gives you an idea how much of the pay is linked to performance."

Tharp, who is also president of the National Academy of Human Resources, points out salary is about a quarter of CEO pay, so the bulk of their compensation is variable and you want to know "what does it vary on."

Second, investors should look at the annual bonus. Tharp said this is typically one to one-and-a-half times a CEO's salary.

"Is it based on a number that creates value, i.e., cash flow, or same store sales?" he said. 

Also, Tharp says to look at whether it reflect improvements made to gross margins or other measures of profitability.  Third, longer term incentives should include some element of stock or performance shares, he said.  With these, investors need to know on what basis they are given.

Tharp said investors might look to see if the longer term incentives are linked to metrics like growth in earnings per share or a three-year total return in the stock that beats the firm's peers in the industry.

Fourth, like Dolmat-Connell, Tharp wants to know "how much skin" does the CEO and other top-paid executives, have in the game. If they own stock, do they have to keep a certain percentage of it until they retire?  If they do, this means the CEO's future financial well-being is linked directly to the company's, Tharp said. 

"You should also see the extent to which they (CEOs) participate in similar plans for the other employees, the medical plans, the savings plans," Tharp said.  This gives you signals about the corporate culture, and whether there is a sense of fairness.

No Grossups

For Rich Ferlauto, the extra payments companies sometimes give CEOs to help them pay for the extra taxes they receive on extra pay, is a deal breaker. Ferlauto, director of Pension Investment Policy, American Federation of State, County and Municipal Employees (AFSCME),  said CEOs shouldn't get grossups, nor should they get a lot of perquisites.  "Limited perks," he said when asked what is number three on his list of things to look for with executive pay.

First on Ferlauto's list is whether CEO pay is tied to performance, and second, how the pay measures up against the CEO pay at the company's peer group.  Ferlauto likes to look at longer rather than short-term performance to see if pay was indeed fair.

"The three to five year returns on invested capital is a good measure," he said.

Lastly, like Dolmat-Connell, and Tharp, Ferlauto believes executives need to have skin in the game.  He believes "that they be required to hold" stock they received by exercising stock options for a substantial period of time after those options have been exercised.