New Thinking on How to Link Executive Pay with Performance

The topic of executive compensation generates heated discussion. And, because stock options have become the fastest growing segment of executive pay, performance-related pay in particular attracts high-decibel debate. Stock options now account for more than half of total CEO compensation in the largest U.S. companies and about 30 % of senior operating managers’ pay. Options and stock grants also constitute almost half of directors’ remuneration. This trend is relatively new. The takeover movement of the 1980s provided a powerful incentive for companies to introduce compensation schemes tied directly to stock prices. Before that, executive pay was largely a matter of salaries and of bonuses that were paid out only if financial targets were met. It was widely thought that a company’s stock price correlated with its ability to meet certain financial goals. A number of studies, however, cast doubt on the supposed relationship between bonuses, financial targets, and stock prices. For example, Michael C. Jensen and Kevin J. Murphy’s often cited HBR article “CEO Incentives—It’s Not How Much You Pay, But How” (May–June 1990) showed that there was virtually no link between how much CEOs were paid and how well their companies performed for shareholders. In the early 1990s, corporate boards began to highlight shareholder value. They became convinced that the surest way to align the interests of managers with those of shareholders was to make stock options a large component of executive compensation. By the mid-1990s, CEOs and other senior managers found themselves with significant stock and options holdings. As the stock market began its ascent, executive pay mounted. But the correlation between a CEO’s pay and the stock market did not prove that a company was enjoying superior performance: when the market is rising, stock options reward both superior and subpar performance. That’s because any increase in a company’s share price constitutes “positive performance” with conventional stock options. Any increase in share price will reward the holder of a stock option without distinguishing between good performance and bad. The almost 100 % increase in major stock market indexes between 1995 and 1997 exposed this shortcoming. Executives with fixed-price options enjoyed a huge windfall from the long-running bull market that was fueled not only by corporate performance but also by factors beyond management control, such as declining inflation and lower interest rates. How easy is it to earn a positive return when the stock market is rising? For the ten-year period ending in 1997, total return to shareholders—dividends plus increases in the share price—was positive for each of the 100 largest U.S. companies. The huge gains from options for below-average performers should give pause to even the most ardent defender of current corporate pay systems. The huge gains from options for below-average performers should give pause to even the most ardent defender of current corporate pay systems. Fortunately, the gap between existing compensation practices and those needed to promote higher levels of achievement can be bridged. In doing so, all levels of the corporation, not just the top, must be considered. The ultimate goal of providing superior total returns to shareholders can be better accomplished by following three steps: first, by rewarding top managers only when they outperform the competition; second, by determining the real contribution of each business unit to the company’s overall share price; and third, by involving frontline managers and workers in the quest for higher shareholder value. We’ll examine how each of these steps can be carried out. Problems with Pay at the Top For incentive compensation to work, corporate boards must choose both the right measures and the right levels of performance. In principle, stock options employ the right measure of performance for corporate executives who are responsible for the company as a whole. After all, the value of a stock option is driven by the share price, which is the largest component of shareholders’ total return. Some managers protest that shareholders’ expectations are unrealistically high, but the weight of evidence does not support that conclusion. Surveys, for example—whether taken in rising or falling markets—consistently and overwhelmingly report that most CEOs believe their company’s shares are undervalued. Companies are backing up this belief by repurchasing shares at record levels—and studies show that stock prices respond positively to announcements of repurchased shares. In addition, forecasted performance in a company’s own long-term business plans is frequently well above the level needed to justify its current stock price. Finally, companies are increasingly using stock to finance acquisitions. Executives dedicated to increasing shareholder value would not do that if they believed that shares were undervalued. Most CEOs, in short, place a lot of stock in their company’s share price. If stock options set the right measure of executive performance, do they also set the right level? The answer is no. Shareholders expect boards to reward management for achieving superior returns—that is, for returns equal to or better than those earned by the company’s peer group or by broader market indexes. That is how institutional investors distinguish performing from underperforming companies and also how the Wall Street Journal “Shareholder Scoreboard” compares performance in its annual rankings of the 1,000 largest U.S. companies. To help investors monitor executive pay, the Securities and Exchange Commission even requires companies in their annual executive compensation disclosure to report the total return to shareholders relative to their peers or to the market as a whole. But although many boards and CEOs publicly acknowledge the paramount importance of delivering superior returns to shareholders, current stock option schemes reward both mediocre and superior performance. In other words, boards are not setting the right level of performance. The problem lies in the way conventional stock options are structured. The exercise price is established at the market price on the day the options are granted and stays fixed over the entire option period, usually ten years. If the share price rises above the exercise price, the option holder can cash in on the gains. Therefore, fixed-price options reward executives for any increase in share price—even if the increase is well below that realized by competitors or by the market as a whole. Fixed-price options reward executives for any increase in share price—even if the increase is well below that realized by competitors. Consider the following example. A CEO is granted options exercisable over the next ten years on 1 million shares at the current share price of $ 100. If the share price rises by 5 % a year to $ 163 at the end of the period, the CEO will take home a gain of $ 63 million. But if the share prices of competitors grow at 15 % a year during the same period, a convincing argument can be made that the CEO does not deserve to cash in the options. No reasonable board of directors would knowingly approve a plan that offers high rewards for such poor long-term performance. Some stock option plans do target a higher level of performance than standard fixed-price options. Companies such as Colgate-Palmolive, Monsanto, and Transamerica, for example, have recently introduced premium-priced stock option plans. In those plans, exercise prices are fixed at a premium above the market price on the date the options are granted, and they remain at that level throughout the life of the options. The premium is usually 25 % , 50 % , or even 100 % of the market price. At those higher exercise prices, the share price for a ten-year option must rise about 2 % , 4 % , and 7 % respectively each year if the option is to be exercised profitably when it expires. But those rates are still well below historical equity returns and investor expectations. More to the point, because the exercise prices remain fixed, premium-priced options hold no guarantee that the level of performance will be superior. During a period of rising markets, premium-priced options may still reward below-average performance. They also offer little or no reward to executives who outperform their competitors during times of modestly rising or declining markets. The Advantages of Indexing Stock option plans don’t have to be blunt instruments. By tying a plan’s exercise price to a selected index, boards can increase the pay of superior performers while appropriately penalizing poor ones. Let’s assume the exercise price of a CEO’s options are reset each year to reflect changes in a benchmarked index. If the index increases by 15 % during the first year, the exercise price of the option would also increase by that amount. The option would then be worth exercising only if the company’s shares had gone up by more than 15 % . The CEO, therefore, is rewarded only if his or her company outperforms the index. In selecting an index, companies can choose either an index of their competitors or a broader market index such as the Standard & Poor’s 500. The choice requires trade-offs. Stock options indexed to the market are easily measured and tracked. A market index, however, ignores the special factors that affect the company’s industry. Although the S&P 500 index has risen spectacularly over the past few years, industries such as steel, heavy construction, pollution control, and paper products have done poorly in comparison. It is better to judge management’s contribution using a peer group index. However, because many companies have diversified into a wide range of products and markets, it is sometimes difficult to identify a group of peers. Whatever index is selected, indexed options have clear advantages over fixed-price options. Indexed options do not reward underperforming executives simply because the market is rising. Nor do they penalize superior performers because the market is declining. They can keep executives motivated not only in the bull markets everyone has grown accustomed to but also in sustained bear markets. They link pay to superior performance in all markets. Despite their merits, indexed options are likely to meet with opposition. Some objections are rooted in misplaced concerns; others are more fundamental. (See the insert “Misplaced Concerns About Indexed Options.”) Underperforming executives are likely to balk at the more exacting performance standards of indexed options. Indeed, companies committed to providing superior returns to their shareholders will need to carefully consider how switching to indexed options will affect the motivation of their senior managers. In addition, board members, who now receive almost half their compensation in stock grants and fixed-price options, must be persuaded to agree to the same standards for themselves if they are to credibly ask management to accept indexed options. Misplaced Concerns About Indexed Options The idea of indexed options is not new. Yet despite their appeal, very few companies have issued them. There are two possible reasons for that. First, current accounting treatment penalizes the use of indexed options; and second, investors may be concerned about the dilution of the value of their shares. Both concerns are largely misplaced. The Accounting Anomaly. Under present accounting rules, companies must disclose the cost of fixed-price stock options in their financial statements. But they are not required to charge the cost against earnings. In the case of indexed options, however, the difference between the stock price and the exercise price must be reported each year as an expense. It defies economic logic that less costly indexed options must be expensed while more costly standard options are not. But this rule should not be a roadblock against the switch to indexed options. Executive stock options do not become more or less costly depending on whether the disclosure is made in a company’s income statement or in its footnotes. Research shows that stock prices respond to disclosure of relevant information such as the cost of executive stock options. Investors are not fooled, and boards should not use the “investors won’t understand the earnings hit” excuse to avoid implementing value-creating compensation arrangements. Still, the requirement to expense indexed options does discourage companies from adopting indexed option plans. Companies do not voluntarily report lower earnings. The Financial Accounting Standards Board should take the lead by mandating a consistent treatment for all options. The critical choice for the FASB is not between footnote disclosure and expense recognition. What is important is that whatever the choice, it apply equally to all options. That would level the playing field. Bad accounting policy should not be allowed to dictate compensation. Fears of Dilution. Shares reserved for outstanding and future grants under stock option and stock purchase programs have surged during the past few years. More than 13 % of outstanding shares among the 200 largest public U.S. corporations are reserved for such programs, and some investors believe that allocations have reached—if not exceeded—a reasonable upper limit. Because more indexed options than fixed-price options will have to be granted under the proposed conversion scheme, some shareholders might worry that their holdings will be further diluted. That is unlikely, because there is a higher chance that indexed options will expire unexercised than is the case with fixed-price options. While indexed options have only about a 50 % probability of being exercised (because only about half the companies in an index can enjoy superior performance), fixed-price options have had an exercise rate approaching 100 % over the past ten years. Thus if two indexed options were granted in place of each fixed-price option, the increase in a company’s outstanding shares would be about the same. Concerns over dilution should not focus on the number of options granted but rather on the number that can be exercised in the absence of superior performance. Because CEOs can be rewarded for weak performance under fixed-price plans, there is actually a greater risk of dilution with standard plans than with indexed plans. To persuade executives to accept indexed option packages, the packages should be structured so that exceptional performers can earn greater returns than they could with conventional options. Two incentives need to be incorporated into the packages. First, companies should increase the number of options they grant to executives; second, they should lower the exercise price. By taking those actions, boards can get senior managers to tie their pay to superior performance. They would be able to do so because the managers would come out on top with such a plan. The evidence comes from a study conducted by L.E.K. Consulting, which examined the performance between 1988 and 1997 of 170 companies in 23 industries represented in the Dow Jones index. The study found that executives at two-thirds of superior-performing companies would have earned more with indexed options structured along the lines recommended here than they actually did. Increasing the Options. To compensate executives for bearing higher risk, boards will need to offer them more options. To decide how many more, they first need to know how many indexed options would offer the same value as the conventional options that top managers currently possess. I call this number the “value ratio.” Take a typical situation for a company whose share price is $ 100. As calculated by option-pricing models, the estimated value of a conventional stock option is $ 34.50, and the value of an indexed option is $ 21.60. The value ratio is then 34.50 divided by 21.60, or 1.6. The value ratio is affected principally by changes in interest rates, stock price volatility, and the correlation between the chosen index and the stock price. Research conducted by the University of Toronto’s John Hull has shown that although value ratios are sensitive to these factors, in most situations they can be expected to fall in a range of approximately 1.5 to 2.0. But in a competitive market for top management talent, many executives are unlikely to be convinced by such figures and will probably demand more options than the ratios would suggest. Thus in order to entice executives to convert, boards must start by offering them at least two indexed options for every fixed-price option in their current plan. Although many CEOs may be reluctant to shift to a new compensation plan, high-performing ones will do better with indexed options than with conventional options if they convert at a two-for-one rate. Suppose, for example, that a company’s stock price was $ 100 on the day the options were granted and that a peer index was established that had the same price. Over ten years, the index grows at an average of 10 % per year and its price reaches $ 259. The company, meanwhile, grows by 20 % annually so that its share price reaches $ 619. The profit on each indexed option would be $ 619 minus $ 259, or $ 360, while the gain for a fixed-priced option would be $ 619 minus $ 100, or $ 519. If two indexed options had been granted for each fixed-priced option, the gain from the indexed option package would be $ 720—that’s 39 % greater than the $ 519 from the fixed-priced option. (To gauge the impact of different scenarios, see the table “How Much Can Senior Managers Gain from Indexed Options?”) How Much Can Senior Managers Gain from Indexed Options? Superior managers will usually do better with indexed option packages than with conventional packages. And the better a company does relative to the index, the higher the gains. My research also shows that gains from indexed options relative to fixed-price options decrease if options are exercised early. Indexed options thereby encourage managers to stay for the long term. Lowering the Exercise Price. By offering two or more new options for each old one, companies will enable superior executives to earn even more. But only about 50 % of executives can be above average. What about incentives for the others? One response is that they don’t deserve incentive compensation. On the other hand, it’s probably not in the best interest of shareholders to have a group of company executives who are less motivated than they could be because their indexed options are presently worthless. One way to resolve the dilemma is to lower the exercise price for indexed options. There are several ways to do that. The most effective and easiest way is to grant what I call “discounted indexed options”—options whose exercise prices are discounted by some specified rate. A discounted indexed option guarantees an index-generated exercise price while simultaneously allowing managers to profit at a performance level that is modestly below the company’s peer group average. Discounted indexed options sweeten the package. To see how such options would work, imagine a company whose board wants to issue them. The board could discount the selected index by a specified rate each year over the life of the option. For example, if in the first year the index rises from $ 100 to $ 120, a 1 % discount would decrease the year-end index from $ 120 to $ 118.80. Thus the exercise price of the stock would have risen by only 18.8 % instead of 20 % . This approach makes gains from indexed options accessible to more executives. Discounting options also provides further economic motivation for high-performing executives to remain with the company and to hold on to their options. By the end of the ten-year life of the typical option, the cumulative discount on the price of the index would be 10 % . Two additional questions must be answered before CEOs and other senior executives are likely to endorse an indexed option plan. First, how large does the spread have to be between the growth in a company’s share price and the index price before the gains from indexed options exceed those from standard ones? In other words, by how much does a company have to outperform its peers? And second, how difficult is it for companies to reach and surpass the break-even spread? Those questions can be answered by referring to the L.E.K. Consulting study mentioned above. The research shows that a company should outperform its selected index by about 5.4 % for two indexed options to generate greater gains than one fixed-price option. That figure falls to about 3.9 % if one introduces an annual 1 % discount to the indexed options. How easy is it to achieve those spreads? Easier than might be expected. The table “How Many Winners with Indexed Options?” shows, for example, that executives at 64 % of the superior-performing companies in the study would have gained if they had exchanged each conventional option for 2.5 indexed options discounted at 1 % . How Many Winners with Indexed Options? Discounting options and increasing the value ratio makes it easier for companies to reach the break-even spread—the figure that allows holders of indexed option packages to equal the gains they would have obtained under fixed-price plans. The table shows the percentage of superior-performing companies from a total sample of 170 that would have surpassed the break-even spread for different types of indexed option packages. This research, of course, was conducted at a time when the stock market was rising very quickly. The average annual price growth of the S&P 500 index between 1988 and 1997 was 14.7 % ; the figure was 8.7 % for the past 50 years. Would the percentages in the table be affected if price appreciation over the next ten years mirrored the longer-term average? The most reasonable guess is that the percentages would not change significantly. Although the size of break-even spreads is affected by the overall growth of the market or the selected index, the number of companies that reach or exceed that spread is not affected by the state of the market. In the 23 industries looked at in the study, increases in share price ranged on average from 4 % to 24 % per year over the ten-year period. I could find no relationship between those figures and the percentage of companies whose executives would have realized greater gains from indexed options than from fixed-price options. This suggests that discounted indexed options will provide a better deal for most managers regardless of stock market conditions. Judging the Value of Business Units While CEO pay draws intense interest, the compensation of operating managers is far less scrutinized. It is, however, equally critical to the success of public companies. After all, the primary source of a company’s value lies in its operating units. In decentralized companies that have a range of products and markets, operating executives make the important day-to-day decisions and investments. The way those executives are evaluated and paid affects their behavior and the business’s results. In order to close the gaps between pay and performance at the operating unit level, performance targets and incentive pay must be aligned with the interests of shareholders. Otherwise, CEOs will find it difficult to achieve gains from indexed options. Corporate managers are well aware of the importance of motivating operating managers. Performance packages are now the dominant part of the compensation mix at the operating level. Pearl Meyer & Partners, a consulting firm that specializes in executive compensation, reported that for group heads managing businesses with annual revenues of less than $ 1 billion, stock options constituted 27 % of their compensation packages in 1997. Annual and long-term incentive schemes accounted for a further 41 % . Unfortunately, these performance schemes were all based on the wrong measure and wrong level of performance. Challenges of Measurement and Level. Both boards and the public have generally believed that granting stock options would successfully align the interests of operating unit managers and shareholders. But granting options to such managers is even less a guarantee of performance than it is for CEOs. That’s because a company’s stock price is not an appropriate measure of the performance of an individual business unit. Business units are essentially private companies embedded in publicly traded companies. The managers of operating units usually have a limited impact on the company’s overall success or on its stock price. Incentives based on the share price will not give them the rewards they deserve. A stock price that declines because of disappointing performance in other parts of the company may unfairly penalize the executives of a superior-performing operating unit. On the other hand, if an operating unit performs poorly but the company’s shares rise because of superior performance by other units, the executives of that unit will enjoy an unearned windfall. Only when operating units are substantially interdependent can the share price be a fair and useful guide to operating performance. Granting stock options to business unit managers is even less a guarantee of performance than it is for CEOs. One can find measures in other incentive schemes that focus better on operating unit performance but are unreliably linked to superior performance. The most frequently employed financial measures include operating income, return on invested capital (ROIC), and return on equity (ROE). Earnings measures are not reliably linked to shareholder value because they do not incorporate the cost of capital and may be calculated using different accounting methods that can produce different numbers. ROIC and ROE have similar accounting shortcomings. A growing number of companies have also embraced residual income measures, such as economic value added, which deduct a cost of capital charge from earnings. The resulting calculation is thought to be a good estimate of the value added by the business, but these measures also suffer from accounting problems. The most important problem, however, is that schemes using residual income measures typically set too low a level of minimum performance. This conclusion may surprise many managers. It is well established that management creates value when the returns on corporate investments are greater than the cost of capital. But that does not mean operating executives should be rewarded for any value created. Using the cost-of-capital standard as a threshold for incentive compensation ignores the level of added value already implied by a company’s stock price. Imagine a corporation whose cost of capital is 10 % . The price of its shares reflects investors’ belief that the company will find opportunities to invest and operate at an average expected rate of return on investment of 20 % . If managers start to invest in projects yielding less, say 15 % , investors will revise their expectations downward and the company’s shares will fall correspondingly. Few would argue that a manager should be rewarded for such performance, even though he has exceeded the cost of capital. How often does this gap occur between expected return on investment and the cost of capital? Although the differences vary widely from one industry to another, the share prices of virtually all publicly traded companies reflect the expectation that they will generate returns well above the cost of capital. According to a study by L.E.K. Consulting, for example, the median baseline value for the 100 largest nonfinancial companies is approximately 30 % of their stock price. In other words, if investors expected these companies to earn returns at the cost of capital, their shares would be priced at about 70 % below current levels. (See the table “Expected Rates of Return Compared with Costs of Capital.”) Expected Rates of Return Compared with Costs of Capital Credit Suisse First Boston, using their own value-driver estimates, including the cost of capital, calculated the expected or minimum rates of return on investment needed to justify September 1998 share prices for the Dow Jones industrial companies. In every case, the expected returns were greater than the cost of capital. The potential for undeserved payment is very high when cost of capital is the threshold. That is as true for business units as it is for corporations, and it applies whenever performance is based on accounting or residual income measures. That’s because those measures rely on a company’s historical investment rather than on the benchmark against which investors properly measure their returns—the company’s current market value. The Superior Shareholder-Value-Added Approach. How is pay to be set using the right measure at the right level in a business unit? The best way is by valuing a unit as if it were a stand-alone business. The parent’s share price, after all, largely reflects the aggregate expectations of its operating units. One way to evaluate business units is by considering “shareholder value added.” SVA has one clear advantage over residual income measures: it is based entirely on cash flows and does not introduce accounting distortions. It can therefore serve as a sound basis for an incentive pay plan. SVA puts a value on changes in the future cash flows of a company or business unit. It is calculated by applying standard discounting techniques to forecasts of operating cash flows for a specific period and then subtracting the incremental future investments anticipated for that period. If a company is to deliver superior returns to its shareholders, its units must create superior SVA. Calculating superior SVA requires six steps: First, develop expectations for the standard drivers of value—sales growth, operating margins, and investments—by factoring in historical performance, the unit’s business plan, and competitive benchmarking. Second, convert the expectations about value drivers into annual cash-flow estimates and discount them at the business unit’s cost of capital in order to obtain the value of each operating unit. Third, aggregate the values of each operating unit to verify that the sum is approximately equal to the company’s market value. Fourth, from the cash flows used to value the operating unit, establish the annual expected SVA over the performance period—typically three years. Fifth, use year-end results to compute the actual SVA at the end of each year. The calculation will be the same as in the previous step, with actual numbers replacing the estimates. Sixth, calculate the difference between actual and expected SVA. When the difference is positive, you have superior SVA. Value creation prospects can vary greatly from one business unit to another. An approach based on expectations establishes a level playing field by accounting for differences in business prospects. Managers who perform extraordinarily well in low-return businesses will be rewarded, while those who do poorly in high-return businesses will be penalized. The Hierarchy of Performance Measurement At what level of performance do you start rewarding business unit managers with pay for performance? The right answer would seem to be, “When they create superior SVA in their units.” But just as they may with indexed options, boards may wish to set their SVA threshold targets at a discount. Setting a threshold that is modestly below expected SVA would be appropriate. Indeed, incentive plans for operating managers often set a threshold at 80 % of a designated target. That makes sense, but the converse—imposing a cap—does not. Currently, many plans are capped once performance is greater than 120 % of the target. Such a policy would send the wrong message to operating managers who otherwise would be motivated to maximize SVA. When setting performance pay, it is important to note that value creation is a long-term phenomenon. Annual performance measures do not account for the longer-term consequences of operating and investment decisions made today. So looking at a single year reveals little about the long-term ability of a business to generate cash. To motivate managers to focus on opportunities to create superior SVA beyond the current period, the performance evaluation period should be extended to, say, a rolling three-year cycle. Companies can then retain a portion of incentive payouts to cover against future underperformance. The Front Line’s Contribution Using SVA performance to establish incentive pay is consistent with the responsibilities of the operating unit executive. But measures are needed at every level of an organization in order for it to realize superior total returns to shareholders. Indeed, finding measures that can guide hands-on decision making by frontline workers is the final piece of the puzzle. Although value drivers such as sales growth and operating margins are useful for identifying value-creating strategies and tracking SVA at operating units, they are not sufficiently focused to provide much day-to-day guidance. Middle managers and frontline employees need to know what specific actions they can take to ensure that expectations are met or exceeded. Even setting a three- or five-year performance period may not capture most of the SVA potential of high-growth businesses or of industries such as pharmaceuticals that have extended lags between their investments and their product sales. The solution to both problems lies in identifying what I call the “leading indicators of value.” These indicators can be used both as a supplement to SVA analysis and as the basis for calculating incentives for frontline employees. Leading indicators are current measures that are strongly correlated with the long-term value of a business. Examples include time to market for new products, employee turnover figures, customer retention rates, the number of new stores that are opened on time, and the average cycle time from order date to shipping date. These are all factors that frontline managers can directly influence. My research has shown that for most businesses, three to six leading indicators account for a high percentage of long-term SVA potential. Improving leading indicators is not a goal in itself; it is the basis for achieving superior SVA. The process of identifying leading indicators is challenging, revealing, and rewarding. It takes more than an impressive knowledge of customers, products, suppliers, and technology to understand a business’s sources of value. Operating managers need to identify and focus on activities that maximize SVA and reduce costly investment in resources that contribute little to actual value. Identifying leading indicators helps management find strategies with the highest potential for increasing SVA. The sidebar “Home Depot’s Leading Indicators of Value” shows how one company focuses on certain leading indicators to deliver superior value to shareholders. Home Depot’s Leading Indicators of Value by Thomas H. Nodine Home Depot ranks among the ten largest retailers in the United States. With an annual total return to shareholders of 44.8 % over the past ten years, the company’s performance easily exceeds the industry average of 21.6 % . That extraordinary performance has raised the standards that management must meet in coming years. Over 70 % of Home Depot’s stock price is based on expected shareholder value added coming from future growth. It is essential that the company identify its leading indicators of value—the building blocks for its long-term SVA—in order to maintain its position. The first step in finding leading indicators is to see which of the standard cash-flow drivers of value—sales growth, profit margins, and investments—are critical to a company’s success. At Home Depot, sales growth and profit margin are the critical drivers. Analyzing sales growth reveals two leading indicators of value—growth in new stores and revenue per store. A sensitivity analysis of those indicators reveals how significantly they are correlated with Home Depot’s value. For each 1 % shortfall in new store growth, the company’s value falls by about 7 % . Indeed, store growth is so important to Home Depot that a one-year delay in all currently scheduled new store openings would reduce the company’s value by almost 16 % . The same process can be used to identify leading indicators of value associated with profit margins. These include average retail and wholesale prices, as well as freight, labor, and administrative costs as a percentage of revenues. Understanding the relationship between leading indicators is essential for identifying value-creating strategies. For example, although it is important that Home Depot maintain or exceed projected store growth, the company must not open new stores so quickly that they cannibalize sales at existing stores. Leading indicators also provide management with a more sophisticated way to identify trends. For example, increases in Home Depot’s average retail prices, together with falling average wholesale prices, signal greater future profitability. On the other hand, decreases in Home Depot’s revenue per store as growth continues might indicate market saturation, showing managers that a period of lower growth lies ahead. Home Depot is clearly focusing on leading indicators of value. To promote growth, it is aggressively adding stores in the United States while entering new markets in Canada and Latin America. The retailer is also monitoring store construction to ensure on-time openings, increasing store size to improve revenue per store, and introducing new store formats that promote higher average purchases. At the same time, Home Depot plans to increase margins by buying in bulk and optimizing its mix of products. By continuing to focus on these leading indicators of value, Home Depot’s management can identify value-creating strategies and continue to exceed the high expectations of its shareholders. • • • Achieving superior returns is the ultimate goal for shareholders. It is, therefore, the only appropriate target for the CEO, the board, and corporate-level executives. Companies with superior performance standards in place at all levels send a powerful message to shareholders about their aspirations. The focus on achieving superior returns is consistent with the broader duties of the CEO—the responsibility to be in the right businesses and to allocate the proper amount of capital to them. But the most significant source of superior total returns is the operating unit’s level of SVA. And the building blocks for SVA are the leading indicators that guide frontline managers. Without performance at those levels, shareholders will not be able to maximize their returns, and CEOs will be less likely to realize gains from their indexed options. The concept of pay for performance is widely accepted, but the link between incentive pay and superior performance is still too weak. Boards of directors need to push through changes in executive compensation practices, including their own pay schemes. And reforms must be adopted at all levels of the organization. If indexed options are introduced for CEOs, then SVA-based measures should be introduced in business units. And on the front line, leading indicators should be followed. Shareholders will applaud changes in pay schemes that motivate companies to deliver more value.

New Thinking on How to Link Executive Pay with Performance

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