Why executive pay doesn't matter (to shareholders)
October 14, 2009
PORTFOLIO POINT: Fat pay packets for chief executives have little effect on share prices or earnings.
It's the great Australian barbecue starter: how top executives get paid too much and blue-chip stocks lose their way thanks to corporate greed.
But is it true? Does paying top chief executives highly damage shareholder value? In very big companies with billions of dollars in market capitalisation, the truth is a $1 million more or less on a chief executive's salary makes little difference.
Admittedly in this Eureka Report exercise we only ran the numbers at three companies, but the answers indicate the outcome on a larger sample would be very similar.
Following the recent release of the productivity commission's report on executive pay, there is a tangible sense of change in this area:
Key recommendations from the report included:
- Giving shareholder votes on executive remuneration more "teeth" by requiring boards to stand for re-election if shareholder concerns on consecutive remuneration reports are ignored.
- Introducing a "two-strike" rule whereby if 25% of shareholder votes oppose executive pay at an AGM and an unspecified amount the second year, the board would be forced to stand down.
- Remuneration committees should have a majority of independent members.
- Executives should be banned from hedging any part of their remuneration (such as unvested company shares) so that the "market-linked" component of their salary remains linked to market returns.
- Institutional investors should be more transparent in how they vote.
The report received a lukewarm response from corporate Australia, with a number of market leaders - including Commonwealth Bank (CBA) chairman and BHP Billiton (BHP) director John Schubert - actively campaigning against some of its recommendations.
Shareholder representative groups have welcomed the report. Helen Dent, chair of the Australian Shareholders Association, says the proposed changes are "unarguably in the best interests of shareholders". She says the recommendations are important because boards have let "largesse escalate, forcing shareholders to seek greater involvement".
The Productivity Commission also seems to hint at some largesse - noting that since 1993 executives have enjoyed a 250% salary increase, on top of inflation, and that the average package for Australia's top 20 chief executives now approaches $10 million a year. Dent further suggests that "directors will no doubt resist this measure, saying it goes too far".
With the top 20 being paid such hefty amounts, it is, of course, is perfectly valid to question executive pay. But for investors the issue is whether this affects the value of their shares.
In looking at the top five executive salaries at each of three widely held companies - Telstra (TLS), Commonwealth Bank and Qantas (QAN), the reality is that even cutting them $1.16 million each would have a noticeable, but not hugely significant, impact on the earnings and share price of companies.
To calculate of the effect of executive salaries, we have had to start by suggesting what is a "reasonable" pay level, from which we can determine which salaries are in excess of this level.
One of the models for limiting executive pay that has been ruled out through the Productivity Commission report is that of a "salary cap", or upper limit of possible pay. Although this has been ruled out (and I can understand why) I have invoked a version of it to help with the calculations.
The working week for most people is a little over 40 hours. I have assumed that executives put in an effort approximating three times this, with early mornings, late nights and weekends.
Further, their responsibilities are greater than the average employee, so rather than the average worker's $30 an hour, my suggestion is that a "reasonable" level of salary should be five times this amount.
My suggestion for an (admittedly) simplistic cap on executive remuneration is that they be paid 20 times the average worker's income, or $1.16 million a year. As an interesting comparison, this is a little more than three times the salary of Prime Minister Kevin Rudd.
The process I have used to calculate the per-share effect of remuneration paid in excess of this $1.16 million level is:
1. Consider how much would be saved by paying the top five executives a cap of $1.16 million a year.
2. Divide this amount saved by the number of shares on issue to calculate the increase in the earnings per share.
3. Multiply this increased earnings per share by 15 (based on a long-run market valuation of companies of a price/earnings (P/E) multiple of about 15) to calculate the increased value of the shares.
4. Assume that the increased earnings are invested in a project returning 12% a year, which provides future earning benefits for investors.
5. Extend these calculations over a 10 year period.
It should be noted that for the data I have used in the remuneration summary of the most recent annual report for the company. It includes the five highest-paid executives for the company and looks at the total remuneration for each, which may include payments that are at risk.
Total accumulated cost 55¢ per share over 10 years
Starting with Commonwealth Bank, the remuneration above the level of $1.16 million per executive comes to a total of $17.9 million for the top five. This equates to about 1.2¢ per share; in other words, if executives were only earning $1.16 million each, earnings per share would lift by 1.2¢.
For companies on a P/E of 15, this would lift share prices by about 13¢ - not a huge increase, but noticeable at the individual shareholder level. Over 10 years, the increase of 1.2¢ of earnings each year, re-invested into projects producing a return of 12% a year, will lead to a theoretically increased share price of 55¢ a share.
With the current share price of $50 a share, it is interesting to consider what this means for an investor with a $50,000 holding. Cutting salaries to $1.16 million would increase the value of that $50,000 package by $130, and over 10 years it would rise by about $550. Neither are huge amounts, but it is possible to see an impact from executive remuneration at the level of the individual shareholder.
|nCommonwealth Bank: 10 year effect of cutting top five salaries to $1.16 million
Total accumulated cost of 7¢ a share over 10 years
Telstra's executive remuneration has more impact on individual shareholders than Commonwealth Bank, an interesting result given the poor performance of Telstra over the past decade. The payments above the $1.16 million each for the top five executives totalled $19.3 million.
Limiting executive pay to $1.16 million would lift a $50,000 Telstra holding, at the current price of $3.25, by $360 immediately and by $1118 over 10 years.
Over 10 years the increase of 0.2¢ of earnings each year, reinvested into projects producing a return of 12% a year, would lead to a theoretically increase in the share price of just over 7¢.
|nTelstra: 10 year effect of cutting top five salaries to $1.16 million
Total accumulated cost 45¢ a share over 10 years
Qantas's latest annual report included the remuneration of a number of executives entering retirement; however their income was below the previous year, suggesting this was not artificially inflated by any "golden handshakes".
They paid their top five executives a total of $21.7 million above the $1.16 figure. This is the highest level of executive salaries among the three companies, and its impact will be greatest on shareholders because it is a significantly smaller company than Telstra or Commonwealth Bank.
Cutting packages to $1.16 million would save 1¢ a share, or a potential 15¢ increase in the market price if priced on a P/E of 15. Reinvesting these extra earnings would lift the share price by 45¢ over 10 years. That would lift a $50,000 holding by $2000 immediately or by $7700 over 10 years.
|nQantas: 10 year effect of cutting top five salaries to $1.16 million
The calculations for Qantas, Commonwealth Bank and Telstra show that big salary packages to affect earnings and share prices, but not to a great level. Indeed, if a highly skilled executive were able to increase shareholder return by 1% a year, they would justify the paying of a high salary.
The more interesting story is that of the Productivity Commission recommendations and its recommendations to give shareholders more power to vote on executive remuneration, recommendations supported by the shareholders' association.
Moves away from continued salary increases well in excess of inflation, to genuinely involving shareholders (company owners) in the remuneration process, would seem to be a step in a positive direction.