Friday, December 11, 2015

How CEO Incentives Drive Financial And Corporate Investment Decisions

This article (via Manan Shukla) explains why F500 corporations spent a record $520 billion repurchasing their own stock.  Stock buybacks and dividend payouts were greater than capital investments and twice the amount spent on research and development.  One of the factors that determine the level of buybacks and dividend payouts is their linkage to CEO bonus payouts.  They can also affect the behavior of institutional investors who make stock investment decisions based upon the total return per share of stock.

Executive compensation was changed in 1992 by a law which placed constraints on cash salary awards and caused corporate boards to link CEO compensation to performance.  Earnings per share (EPS) is commonly used as a performance measure.  This is a good measure of performance if earnings increase due to superior operating performance.  However, EPS can also be increased by reducing the number of shares outstanding.  That is accomplished when corporations repurchase their own stock.  Stock repurchases may be a good use of capital if the stock is undervalued, or if no better use of capital is available.  This article provides several examples of corporate stock buybacks which may have been used to help a CEO hit an EPS bonus target.  In other words, some CEO's may have found a way to game the pay for performance requirement.  Hitting EPS targets also influences investors.  They may invest in firms which hit EPS targets.  This drives up the stock price and it increases the value of stock options held by CEO's.

Investor behavior has also changed.  The average holding period for a stock was 8 years in 1960.  Today the average holding period is only 1.5 years.  Many investors determine the total return on a stock investment by adding EPS to dividend payout per share.  Boosting EPS and increasing dividend payouts can increase the short term demand for a stock and drive up its price.  Unfortunately, EPS can be manipulated in ways that have little to do with operating performance. Stock buybacks are one way to increase EPS but cuts in capital spending and R&D can also boost EPS at the expense of long term growth.  Most investors are only concerned with short term performance since the average holding period is only 1.5 years.

The take away from this article is that corporate decision making is driven by CEO financial performance metrics.  The goal is to connect executive decisions to the desires of investors.  The system can be gamed, especially if corporate boards are too close to the CEO's who often recruited them to the board.  It also focuses management attention on the motivations of short term investors. That may not be good for investors who have a longer time horizon that most investors.

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