Post on 09-Oct-2020
Munich, January 7, 2020
Pay for performance – What is performance?
Prof. Dr. Christian Aders
Pay for performance – What is performance?
2
Source: The Wall Street Journal, May 3, 2016.
Agenda
Table of content
1. Basic principle of performance measurement and compensation
2. Performance from the shareholders‘ perspective
3. Performance from the management’s perspective
4. Value-based performance measurement on the basis of value/book value based target returns
ValueTrust Financial Advisors SETheresienstraße 1
80333 Munich
Germany
www.value-trust.com
3
Basic principle of performance measurement and compensation
1
Basic principle of performance measurement and compensation – theory
Investor(Principal)
Management (Agent)
Incentive compatibility through compensation contracts
5
▪ Reduction of the Principal-Agent dilemma and creation of incentive compatibility between investors and management through compensation contracts
Conclusion
Information asymmetry
Basic principle of performance measurement and compensation – common practice
„Human beings adjust behavior based on the metrics they‘re held against. Anythingyou measure will impel a person to optimize his score on that metric. What youmeasure is what you‘ll get.“
Source: Dan Ariely, Harvard Business Review, June 2010.
6
▪ What is performance from the perspective of the shareholders?
▪ What is performance from the perspective of the management?Conclusion
Performance from the shareholders‘ perspective2
Shareholders measure the performance of their investment resp. of the company by means of the Total Shareholder Return (TSR)
8
▪ For the assessment of the actual performance, the TSR must be evaluated in relation to the actual performance of the benchmark and the planned performance
Conclusion
(Closing stock price – Opening stock price) + Dividends
Opening stock priceTSR =
Dividend yield
Share performance
TSR
Plan/actual performance of the benchmark using the capital markets of the DACH region as an example
Source: ValueTrust
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▪ The ATX/DAX/SMI companies realized an average TSR of about 9.0% in the last 4 years
▪ The implied cost of equity (= expected TSR), derivable from the stock prices and net income estimates, currently amount to about 9.2% for the ATX/DAX/SMI
Conclusion
Implied market return & TSR – ATX/DAX/SMI
9,4% 9,7% 9,6% 10,9% 10,4% 9,5%8,8% 8,3%
7,8%8,3%
7,8% 8,0% 8,1% 7,9%
12,9%
10,6%
0,0%
2,0%
4,0%
6,0%
8,0%
10,0%
12,0%
14,0%
16,0%
H1 2010 H2 2010 H1 2011 H2 2011 H1 2012 H2 2012 H1 2013 H2 2013 H1 2014 H2 2014 H1 2015 H2 2015 H1 2016 H2 2016
Implicit market return & TSR - ATX/DAX/SMI
Range (25% - 75% Quantil) of the impl. market return Market value-weighted mean of the impl. market return Ø TSR 2010-16 Ø TSR 2013-16
If the shareholders' expectation, which is included in the stock price, are met, the actual performance equals the cost of equity resp. the expected TSR
Cost of equity
Shareholders‘ expectation
regarding company
performance
= Actual company performance =
Total Shareholder Return (TSR)
! !
10
▪ How can the shareholders‘ performance expectations be exceeded? Question
Outperformance from the shareholders‘ perspective is „Under promise and/or Over perform“ from the perspective of the management
Shareholders‘ expectation
regarding company
performance
= Actual company performance
RealizedTSR
=Originally
expected cost of equity
Management of shareholders‘ expectations
Outperformance of “internal“ targets
Excess return for
shareholders
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▪ In order to generate excess return for the shareholders, management must exceed the shareholders‘ expectations
▪ If this leads to an adjustment of the shareholders‘ expectation (and share performance), the „Expectations Treadmill“ will start
Conclusion
The Expectations Treadmill is difficult to beat in the long term and can lead to disincentives
* Source: Koller / Goedhart / Wessels: Valuation (2015), p. 50 f.
„If the company beats expectations, and if the market believes the improvement is sustainable, the company‘s stock price goes up, in essence capitalizing the future value of this incremental improvement. This improves TSR.
But it also means that managers have to run even faster just to maintain the new stock price, let alone improve it further: the speed of the treadmill quickens as performance improves.“*
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▪ For every performance enhancement, which will be priced in the current stock price, management has „to run even faster“, in order to achieve additional excess return (Expectations Treadmill)
Conclusion
55%40%
30%
45%60%
70%
0%
20%
40%
60%
80%
100%
CH A D
Ja Nein
After all, the ex post realized TSR is frequently used in practice as KPI for the management compensation (example DACH region)
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Source: ValueTrust analysis based on the annual reports 2015; * Note: the compensation structure of CA Immobilien (ATX) cannot be determined
TSR as performance indicator in the DACH region (SMI/ATX/DAX)
▪ No explicit TSR target (neither absolute nor relative) is used by the companies in the DACH region
▪ Between 10% (DAX) up to 30% (SMI) of the companies report the TSR as performance indicator
TSR as compensation indicator in the DACH region (SMI/ATX/DAX)
ValueTrust analysis
▪ In the SMI the TSR is applied on 55% of the 20companies within the scope of a compensationprogram. A peer group comparison is mainly used
▪ The TSR is integrated in a compensation program for 8of the 20 ATX companies (40%). For 5 companies arelative performance measurement featuring a peergroup as benchmark is used. For two companies a indexis used as a benchmark*
▪ 30% of the 30 DAX companies have integrated the TSRin a management compensation program
Yes No
In the US the TSR is currently the dominant indicator for the management compensation
Meridian Corporate Governance & Incentive Design Study 2018
Target setting
* Absolute and relative TSR
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Usage of the relative TSR in US companies
Applied compensation indicators in US companies
▪ 200 listed US companies („Meridian 200“) were examined
▪ For the performance measurement by means of the relative TSReither a market index or a peer group comparison is used as areference
▪ If the TSR is used, it is the sole performance indicator in 18% ofthe cases and it is used parallel to several performance indicatorsin 82% of the cases
82%
12%
8%
64%
36%
Yes
No
6%6%
88%
Multiple one-year targets
Multiannual targets
One-year targets with Vesting
Net incomeRevenueTSR* Operating income
Profitability indicators
OtherEPS
26%
Cash Flow
64%
30%
44%
21%17% 16%
4%
The TSR correctly measures the performance from the shareholders‘ perspective but is problematic for the performance measurement of the management
„ExpectationsTreadmill“
Definition peer group (in case of relative TSR)
Time horizon measurement TSR (in case of multiannual TSR)
Mispricing of stocks (Speculation & value gaps)
Problem area of the TSR performance measurement
General capital market fluctuations
(e.g. Brexit, QE, etc.)
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▪ The usage of the TSR as sole indicator for the performance measurement is not advisable
▪ The TSR is in particular relevant for the development of targets resp. „Stretch Targets“ for value optimizing corporate planning
Conclusion
Integration into company internal
performance indicators(Portfolio Management)
Performance from the shareholders‘ perspective (TSR) and from the management’s perspective (TVR) have to be differentiated initially and only randomly match
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▪ The Total Shareholder Return (TSR) illustrates the return that is achieved on the market capitalization from the shareholders' perspective
▪ The Total Value Return (TVR) computes the periodic return on the intrinsic enterprise value from the perspective of the management
Conclusion
Dividend yield
Share performance
Total Shareholder Return (TSR)
Dividend yield
Return from an increase of the intrinsic valueTotal Value Return
(TVR)
Performance from the management’s perspective3
Performance from the perspective of the company aims at sustainable increase of the intrinsic value and closure of value gaps
Time
Intrinsic value/ stock price
Goal to permanently increase the intrinsic value
The stock resp. market price fluctuates around the intrinsic value
Through capital market communication the range of fluctuations decreases
Value gaps
Intrinsic value
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▪ To increase the market valuation through the stock market resp. the stock price is, a sustainable growth of the intrinsic enterprise value is necessary which requires value optimizing business planning
Conclusion
Value optimizing planning und target setting requires the analysis of the value drivers implied in the current market valuation
GrowthReturn on Equity/Capital(ROE / ROIC / ROCE)
Excess return (Value Spread)
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▪ The company strategy, the TSR expectations of the shareholders and the performance of the competitors resp. of the peer group determine whether there is potential for value enhancement the company
Conclusion
Fundamental value drivers
!Value Spread
Analytically the TSR and the value drivers cost of equity, value spread and equity/capital return (ROE, ROIC und ROCE) correlate functionally and link shareholder (external) and company (internal) perspective
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Dividend yield
TSR
Cost of capital
=
Dividend policy
Anorganicinvestments
Organic investments
ROE / ROIC / ROCE
Share performance
Growth
External Internal
Cost of equity
Positive correlations can be verified also empirically between TSR resp. market-to-book-ratio and value spread for the capital markets of the DACH region
Equity Value Spread vs. TSR Equity Value Spread vs. M/B
Note: ValueTrust analysis.
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▪ TSR and equity return benchmarking with the „Best Practice“ peer group is necessaryConclusion
ValueTrust analysis
y = 14,035x + 1,6252R² = 0,5519
0,0x
1,0x
2,0x
3,0x
4,0x
5,0x
6,0x
7,0x
8,0x
9,0x
10,0x
-20,0% -10,0% 0,0% 10,0% 20,0% 30,0% 40,0% 50,0%
Ø M
/B 2
01
3-2
01
8
Ø Equity Value Spread 2013-2018
y = 0,592x + 0,081R² = 0,2052
-30,0%
-20,0%
-10,0%
0,0%
10,0%
20,0%
30,0%
40,0%
50,0%
-20,0% -15,0% -10,0% -5,0% 0,0% 5,0% 10,0% 15,0% 20,0% 25,0% 30,0%
Ø T
SR
20
13
-20
18
Ø Equity Value Spread 2013-2018
TSR and peer group benchmarking is necessary for the validation of the ambitions of the business plan („Stretch Target“)
Current market expectation with
regard to TSR resp. cost of equity
andplanned ROIC resp.
growth
Benchmarkingwith peer groupwith regard to
TSR, ROIC,growth
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▪ The reconciliation of the current market valuation with the strategy resp. planning of the management and with the performance of the competitors allows to question the feasibility and ambition of the company planning
Conclusion
Currentintrinsic
EnterpriseValue
„Target“-Enterprise
Value
Capital productivity (ROIC / ROCE)
Profitability (ROS)
Corporate portfolio / growth (g)
Capital structure und tax policy (WACC)
Val
ue
dri
vers
Value-based performance measurement on the basis of value/book value based target returns
4
Value optimizing performance measurement links shareholder and management perspective
Planned figures derived from value optimizing planning include TSR expectations
Performance measurement of equity returns on
the basis of plan/actual comparison and through
benchmarking with a „risk equivalent“ peer
group is a robust and incentive compatible
approach*
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▪ Attaching the performance measurement solely to the plan/actual comparison, neglects unexpected environmental influences and incentivizes conservative planning („Gaming“)
▪ Relative performance measurement in comparison to the risk equivalent peer group can reduce the impact of unexpected and uncontrollable environmental developments
Conclusion
* Source: Velthuis / Wesner: Value Based Management (2005), S. 77 f.
Plan cash clow T
Plan cash flow n
Plan Cash Flow T
Plan cash flow 1
„Target“enterprise
value
t
(Detail) planning horizon
Planreturn n
Planreturn 1
Planreturn
vs.
vs.Actualreturn peer group
Performance measurement
Actualreturn company
The value/book value ratio is the transmission mechanism between shareholder and management perspective
25
Benchmarking with peer group
Shareholder expectation (TSR)
Actual returncompany
Actual return peer group
Strategy & company planning
Shareholder perspective Management perspective
Target return (book value)
value/book value
ratio
„Target“ Enterprise Value
The „target“ value/book value ratio determines the target return
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* Simplified without growth in the terminal value model
Value/book valueratio
Target return
Cost of capital
„Target“ value spread* Price/book value
ratio
Target market value
Book value
„Target“ Enterprise Value
Book value
▪ Value optimizing target setting and performance measurement manifests in the setting of target returns on the basis of a intrinsic „target“ enterprise value
▪ In order to close value gaps resp. undervaluation the value/book value ratio and the market(price)/book value ratio have to converge
Conclusion
!
Shareholder perspective Management perspective
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