December 13, 2005

Excerpts: The Battle For The Soul of Capitalism - Part XV

By: 800-CEO-READ @ 6:30 PM – Filed under: Management & Workplace Culture

The Flaws of Stock Options

Even if executives were required to hold most of their stock for an extended period, however, the fixed-price stock option is fundamentally flawed as a method of aligning the interest ofownership and management:
  • They are not adjusted for the cost of capital, providing a free ride even for executives who produce only humdrum returns.*
  • They do not take into account dividends, so there is a perverse incentive to avoid paying dividends.
  • Stock options reward the absolute performance of a stock rather than its performance relative to peers or to a stock market index.

As a result of these conceptual flaws, executive compensation takes on the appearance of a lottery, creating unworthy centimillionaires in bull markets and eliminating rewards even for worthy performers in bear markets. By making the incorrect presumption that stock price, and stock price alone, is the measure of executive performance, we produced undeserving executive celebrities and overlooked those who incrementally and consistently added real value to their corporations.

These problems were well known, and simple solutions to the executive compensation morass were readily available. Restricted stock, in which executives are awarded shares of the company and required to hold them to earn their rewards, were one obvious alternative. Companies also could have raised the option price each year or linked the stock performance with the performance of the overall market, or with a peer group. But such sensible programs were almost never used. Why? Because those alternative schemes would have required corporations to count the cost as an expense. This recognition of compensation expenses would have reduced the earnings that they were trying to drive ever upward. Largely because their costs were conspicuous by their absence on companies’ expense statements, fixed-price options became the universal standard. Rather than consider compensation plans that made sense for the business, the self-imposed constraint of expense avoidance framed the discussion of executive pay.

As the compensation consultants are wont to say, these stock options are “free.” That singular, simple anomaly bears much of the responsibility for the staggering increase in these payments over the years. But stock prices are inherently flawed as a means ofcompensation. Uncritically, we came to accept stock prices as a measure ofexecutive prowess and success, ignoring the fact that short-term fluctuations in stock prices are based only tangentially on the level ofcorporate earnings (even earnings that are accurately stated). Rather, short-term prices are driven by speculation, reflected in how many dollars investors are willing to pay for each dollar of earnings on any given day. But in the long run, as I will show in chapter five, virtually 100 percent of the return on stocks is determined by dividend yield and earnings growth.

*The cost of corporate capital is generally described as the risk-free interest rate plus an equity premium. In early 2005, approximately 4-1/4 percent on the U.S. Treasury ten-year note, plus, say, 3 percent. Total cost of capital, 7-1⁄4 percent.

link to book