In publicly-traded companies, there is a separation between the ownership and their management. Executives may take actions that benefit them, with shareholders bearing the cost of their behaviors. These costs are generally known as agency costs. To prevent executives from making decisions that better themselves at the expense of stakeholders, companies, and boards of directors use performance metrics to evaluate management performance and award compensation.
Performance Metrics Overview
The use of metrics depends on the company’s strategy and operating environment. Certain metrics are broadly used in many companies (such as ROI, EVA, and EBITDA). A limited number of companies use others. For example, sales per square foot are popular among companies in the retail trade sector. This metric allows retail companies to assess the efficiency of a store’s management in creating revenues with the amount of sales space available to them. Real estate is one of the highest costs for retailers. The efficient use of real estate shows that management is getting more profit out of this type of asset.
Performance metrics can be grouped into two categories: financial and non-financial metrics. Financial metrics are usually based on profit (EPS, EBITDA), growth (revenue growth), return on investment (total shareholder return, ROI, EVA), and free cash flow. Non-financial metrics may involve measures such as customer satisfaction, market share, environmental safety, on-time delivery, and R&D productivity.
Research generally supports the notion that companies tend to use a mix of financial and non-financial metrics to measure management performance. Compared to financial metrics, non-financial metrics are more difficult to track with accuracy. According to a study by Deloitte in 2007, 90% of board members claimed that they did not receive any high-quality information related to non-financial metrics. 59% of the respondents also said that the reason for the lack of high-quality information was because the company has undeveloped tools for tracking such metrics.
The Impact of Compensation Mix on the Use of Metrics
Compensation packages are structured to ensure that executive incentives are in line with the company’s objectives. Companies design their compensation packages by using a mix of cash, equity, and other benefits with appropriate performance metrics. As stated by a study conducted by Equilar in 2014, in an average company, CEO’s compensation comprised 29% in annual salary, 20% in bonus, 14% in stock options, 32% in restricted stock, and 6% in pension and benefits. The way a company builds its compensation mix has a significant impact on the company’s use of metrics.
Short-term incentives are often expressed in terms of a target award. Executives will receive an annual cash payment as a percentage of the base salary for achieving the desired objectives. Because these objectives are short-term by nature, the selected performance metrics are usually a combination of accounting measures (such as EVA, EPS growth, and ROA), stock market measures (such as P/E ratio), and non-financial measures (such as R&D productivity, customer satisfaction). According to a study carried out by Equilar in 2013, the most frequently used financial metric among S&P 500 companies was revenue. Revenue constituted 20.2% of all the financial metrics used in annual incentive plans. EPS and operating income were the second and third most frequently used financial metrics, respectively. These metrics give executives an incentive to improve short-term performance by meeting operating targets.
Besides cash incentive plans, companies also use discretionary plans, which do not have rigidly measurable financial targets. At companies with these plans, the compensation committee decides the final executive payout. As indicated by a study by Equilar in 2013, 72% of companies from the S&P 500 had a quantitative incentive plan, which consisted of at least one financial metric. 24% of the company used discretionary plans. Only 4% did not have any annual cash incentive plan.
One problem with short-term incentives is that they may encourage executives to concentrate on short-term accounting results at the cost of long-term value. Thus, these incentives can act as negative performance metrics. For example, a CEO may reduce investments in R&D activities to increase short-term earnings targets, which are tied to his annual bonus. For this reason, long-term incentives are added to the compensation packages to motivate executives to focus on long-term results that benefit shareholders. Long-term incentives are often in the form of stock options, restricted stock units, and performance shares.
Because the purpose of giving long-term incentives to executives is to encourage them to create long-term value, metrics that are linked directly to value creation are usually selected. These metrics include economic profit, growth, and ROIC. For instance, while EPS growth can come from changes in financial structure, which do not create shareholder value, ROIC better reflects how well a company is using its capital to generate returns.
The Use of Metrics in Comparable Companies in the Retail Trade Sector
The five companies that I chose to include in this post to illustrate my points are in the retail trade sector. Those five companies are Wal-Mart Stores Inc., Target Corp, Dollar General Corp, Sears Holdings Corp, and Family Dollar Stores.
Walmart Stores, Inc.
Most of Walmart’s target direct compensation (TDC) of Named Executive Officers (NEO) depends on how NEOs achieved specified performance targets related to key metrics. Those metrics are operating income, sales, and ROI. All of the metrics that Walmart uses are accounting-based.
First of all, by combining operating income, sales, and ROI, Walmart can reduce the risk that their executives only want to pursue results of one metric to maximize the payouts they receive. For example, if executives make a plan to increase sales but negatively impact operating income or ROI, their incentive pay that is built on sales may grow, but it will be offset by decreases in incentive pay based on operating income and ROI. Second, sales and operating profit are short-term incentives, while ROI is a long-term incentive. This combination of short and long-term metrics helps Walmart reduce the risk that executives may take excessive risk in the short-term to improve performance but may cause damages to the company in the long term.
Target focuses more on long-term incentive (LTI) program rather than a short-term incentive plan (STIP). As a result, the company’s executives have not earned any financial payouts under STIP over the past two years. The metrics that Target uses to evaluate its executives’ performance and contributions are total sales growth, digital channel sales growth, EBIT growth, and return on the invested capital modifier. All of the metrics that Target implements are accounting-based.
First of all, total sales growth is chosen because Target wants to increase localization and personalization. For the second metric, currently, Target is developing a multichannel strategy that enables its customers to engage with the company anywhere, anytime. This is the reason why Target chooses digital channel sales growth as its second metric. Besides, EBIT growth is determined because Target wants its profit to grow sustainably, and this growth is fueled by optimizing expenses. Finally, return on invested capital modifier is chosen because, as said earlier, Target concentrates on its long-term incentive program rather than its short-term plan. To sum up, the metrics that Target uses are chosen because of the company’s strategies of growing and its emphasis on a long-term incentive plan.
Dollar General Corp
Incentive compensations at Dollar General are performance-based. NEOs are also exposed to the fluctuations in the price of common stock. The metrics that Dollar General uses are adjusted EBITDA/ROIC, adjusted EBIT, and adjusted EPS. All of the metrics are accounting-based.
NEOs are given performance share units if they meet the EBITDA/ROIC goals. EBITDA is chosen as it is used to evaluate the company’s profitability in stock analysis. It is one of the most widely-used performance metrics. Dollar General wants to ensure that its NEOs are trying their best to make a profit at a stable stock price. However, since EBITDA does not include tax or capital expenditure, such as depreciation and amortization cost, it is not effective when it comes to evaluating NEOs’ performance in the long run. As a result, Dollar Tree puts 50% weight in ROIC (EBITDA weighted 50%). By using ROIC, Dollar General can see whether the projects that it has invested in bring value to shareholders.
EBITDA and ROIC are used together to make sure that invested capital is providing an appropriate return over time, and the interests of NEOs align with shareholders’ interests. The second metric is adjusted EBIT. Because adjusted EBIT provides measures of performance in the short term, it is used for the sole purpose of rewarding eligible employees of cash bonuses in the 2014 Team Share Incentive Program. Lastly, adjusted EPS is used to evaluate the company’s performance from the perspective of investors. The ultimate goal of Dollar General’s executive compensation program is to serve the long-term interests of its shareholders.
Sear Holdings Corp
Incentive compensations at Sears Holding are performance-based as well as long-term-time-based. The metrics which are used are EBITDA or a combination of EBITDA and business unit operating profit (BOP). The compensation awards to NEOs only become payable following a three-year performance cycle. All of the metrics are accounting-based.
Because EBITDA is a good metric to evaluate profitability in the short term, Sears Holding only offers awards based on three-year performance periods. By doing this way, the company can motivate its executives to focus on long-term performance. BOP is used in combination with EBITDA because Sears Holding wants to assess the performance of not only the whole company but also business units in a given performance period.
Family Dollar Stores
Family Dollar’s compensation programs are designed to balance long-term performance with shorter-term performance. The programs are also made to reduce any risk that a NEO would be motivated to go after results only in regard to a single performance metric or performance period. The metrics that Family Dollar uses are earnings per diluted share, sales per square foot, and return on stockholders’ equity. Out of three metrics that Family Dollar uses, only sales per square foot is neither return-based nor accounting-based. The other two are accounting-based.
The first metric is diluted EPS. It is chosen because the company wants to make certain that compensation is proportional to the return on investment earned by shareholders, and NEOs will try their best to increase diluted EPS. Likewise, sales per square foot and ROE are used because they enable Family Dollar to measure the efficiency of its NEOs in generating profit out of the money invested by investors, thus bringing good returns for them.
Comparison of Metrics Usage across Companies
The most important similarity between all five companies is that all associates and executive officers are prevented from hedging or short-selling company stock. They are also subject to significant restrictions on pledging company stock or anything that can eliminate or limit the risks and rewards of the company’s compensation programs. All companies issued stock ownership guidelines applicable to their NEOs. Another similarity is that all five companies chose metrics that enabled them to measure performance related to sales and profitability. These performance metrics are significant indicators for judging retail performance. Moreover, sales and profitability metrics help companies design competitive compensation programs because they can compare their programs to the programs at other companies.
Walmart: Walmart uses sales, operating income, and ROI metrics to evaluate the company’s performance both in the short-term and long-term. Because good performance with respect to these metrics will transfer into shareholder value over the long term, the company does not use EPS or stock prices as a measure to keep its executives’ interests align with those of stockholders. Another reason why Walmart does not use EPS or stock prices is that the price of Walmart’s common stock has historically been substantially less volatile than the common stock of most of the other retail companies. Therefore, choosing metrics based on stock prices is unnecessary and inefficient for Walmart.
Target: Target wants to make sure that its executives are following transformational plans set by the Board during the important time in Target’s transformation. As a result, it focuses more on the growth aspect of sales figures. The other four companies use sales and profitability metrics to measure their executives’ performance in the short-term.
Dollar General: Dollar General applies pay-for-performance philosophy in its compensation programs. In a way, this is similar to Walmart, as both companies use metrics related to financial performance to determine NEOs’ compensation. However, while Walmart does not use EPS as a performance measure from the investors’ perspective, Dollar General uses adjusted EPS to evaluate its NEOs. A possible reason for this is because Dollar General’s stock prices fluctuate more than the stock prices of Walmart or Target.
Sears Holdings: Similar to Walmart, Sears Holdings uses sales and profitability metrics (EBITDA and BOP) to measure business performance. This is because the company’s compensation philosophy is to encourage growth and create increased stockholder value through the efficient use of corporate assets.
Family Dollar: Unlike the other four companies, the metrics that Dollar Store uses are more direct to shareholders (earnings per diluted share, sales per square foot, and return on stockholders’ equity). The company emphasizes on enhancing stockholder value. It is also the only company to use sales per square foot, which is unique to the retail industry, as a metric. The reason for this is because compared to other companies, the financial results of Family Dollar were not good in recent years. Consequently, the company developed plans to improve sales growth by increasing the number of stores and building customer loyalty. That’s why the company uses sales per square foot metric to measure its progress. In addition, Family Dollar wants to keep track of its investors’ return by using earnings per diluted share and return on stockholders’ equity. The company’s stock price has been volatile because of its negative financial results.
The use of metrics to align executive incentives with company performance targets is one of the most critical factors of short-term and long-term organizational success. Different companies use different combinations of metrics to evaluate their executives’ performance. There are many reasons for the variation in the use of metrics among companies, including, but not limited to, the company’s strategies, plans, past performance, and corporate structures. Regardless of the combined metrics that a company uses, those metrics must reflect the true state of the company’s health and help the board of directors and management navigate the company toward long-term success.