Every year companies spend close to a quarter trillion dollars on executive incentives. The simple fact is that the money could be spent more wisely. Current incentives link pay and performance only weakly and, much of the time, executives are rewarded as much for bad decisions as they are for good ones. Add previously overlooked flaws in accounting and corporate governance and you have a clarion call for action.

This book offers guidance and concrete solutions to companies that need to re-examine their executive compensation policies and practices. The author introduces the salient concept of “value rules,” and shows how to apply these principles — incentive philosophy and financial maxims — to drive the design and use of incentive plans.

Speaking directly to CEOs, CFOs, board members, and other company officers, particularly compensation and HR professionals, this engaging book explains:

• How the most basic ideas in business valuation – the essential connection between business decisions, business results and value creation – expose everything a company needs to know about effective incentive design.
• How current target setting practices, including award schedules, goal weightings and performance ranges, can be transformed from any enemy of value creation into an ally.
• How a whole new range of financial and business measures—or better use of existing metrics—can drive value-creating management decisions
• How common barriers can be overcome to implement a successful business unit-based incentive program.

Testimonials

Table of Contents

Foreword

Chapter 1: To the Typical CEO
• Your Company Could Be More Successful
• Value Rules
• You Don’t Run Your Company
• Senior Management Performance Has Become More Decisive Than Ever
• Your Current Incentives Have Almost Nothing to Do with Your Own Company
• Pay Isn’t Everything
• Creating Value or Taking Stock?
• The Real Incentive System
• This Picture is Coming Soon to a Boardroom Near You
• Everything I Need to Know I Learned in Financial Kindergarten
• Incentive Dynamics
• Bottom Lines
• Endnotes

Chapter 2: The Typical Incentive Structure
• Figure 2-1: Typical Incentive Structure
• What Are We Paying for Management Incentives?
• What Are We Trying to Buy with Incentives?
• Homer’s Performance and Homer’s Pay
• Running the Numbers
• A Drop in the Bucket
• What Did the Money Go For?
• Accounting “Advantages” of Stock Options
• Figure 2-2: Event Study — Stock Price Performance of Expense Announcers vs. S&P 500 Index
• Money Talks. What Do Stock Options Say?
• The Currency of the Realm
• What to Do About It
• Capitalist Tool?
• Figure 2-3: Executive Compensation Elements
• Endnotes

Chapter 3: Incentives and the Role of Management
• Ideas Have Consequences
• Accentuate the Positive, Eliminate the Negative
• It’s Time to Thin the Herd
• Figure 3-1: Drawing Distinctions
• Origins and Effects of Current Incentive Practice
• Off the Rack
• Form Follows Function
• Competitiveness
• Fairness
• Endnotes

Chapter 4: Business Valuation and Incentive Design
• Stealing the Playbook of Business Valuation
• Basic DCF Model Example
• Figure 4-1: Basic Value Drivers
• Figure 4-2: Basic Value Drivers and Discounted Cash Flow Valuation
• Valuation Perspective: Operating Results and Total Capital Usage
• Figure 4-3: Measuring Capital
• Free Cash Flow (FCF)
• Figure 4-4: Uses of Free Cash Flow
• Financial Performance vs. Financing Decisions
• Figure 4-5: The Leverage Effects of Debt on Return on Equity (ROE)
• Income and Capital: Is This Really All You Need to Know About Results?
• Figure 4-6: DCF Scenario with 20% Income Increase
• FCF and the Irrelevance of Accounting Choices
• When Valuing a Business, the Past is Relevant Only as a Prologue
• Figure 4-7: DCF Scenario with Lower Beginning Capital
• Forecast Term FCFs and Residual Values
• Figure 4-8: Zero Value Creation Scenario
• Timing is Everything
• The DCF Model Serves as a Proxy for Other Valuation Methods
• Cost of Capital and Expected Returns
• Figure 4-9: Expected Performance and Total Investor Return
• Value Rules
• Endnotes

Chapter 5: Risk, Executive Behavior and the Cost of Capital
• Investors vs. Management
• A Bird in the Hand is Worth Two in the Bush
• A Bonus Bank is Not a Lock Box
• Liquidity Preference, Not Happy Hour
• Was That a ‘Put’ Option or a ‘Call’ Option We Just Granted?
• Drawing Risk Distinctions
• From the Illusion of Control to Actual Control
• Risk and the Term Structure of Incentive Pay
• Capital-Related Risk Issues
• Growth Bias, Capital Usage and the ‘Total Return’ Plan Format
• Risk Management Policies, Stock-Based Incentives and Top Officer Rewards
• The Wages of Risk: Estimating the Cost of Capital
• Figure 5-1: Weighted-Average Cost of Capital Example
• Beta Coefficients and the Capital Asset Pricing Model
• Financial Leverage and the Cost of Capital
• Other Methods and Evidence for Attaching a Cost to Capital
• Don’t Split Hairs
• Endnotes

Chapter 6: Pay for the Right Stuff — Do’s and Don’ts of Performance Measurement at the Senior Management Level
• Accountability vs. Immunity
• The Rich Are Different
• This Scorecard is Balanced, How?
• Look What They Done to My Strategy
• Does This Matter in the Overall Scheme?
• Endnotes

Chapter 7: Motive, Means and Method — Evaluating Financial Performance Metrics
• A Whole New Ball Game
• Let’s Get Cynical
• Market Practice in Financial Measurement
• Revenue, Volume and Gross Margin
• Figure 7-1: Incentive Plan with Revenue and Operating Income Goals
• Solutions
- Revenue as an Award Modifier
- Figure 7-2: Incentive Plan with Revenue Goal as Award Modifier
- Revenue as a Basis for Future Income Targets
- Revenue and Other Milestones in New Business Ventures
• Using Value Rules to Choose Metrics
• Context for Evaluating Financial Metrics
• Operating Income, EBIT and Return on Invested Capital
• Operating Income and ROIC Solutions
• Two Wrongs Can Make a Right
• Figure 7-3: OI/ROIC Matrix Plan
• Figure 7-4: OI/ROIC Matrix Based Upon Value Creation
• On the Importance of Being Earnest
• Pre-Tax Income, Net Income, EPS and ROE
• Table 7-1: Repurchase Effects with Zero Growth and Debt
• Debt, Share Repurchases, EPS and Stock Option Gains
• Table 7-2: Repurchase Effects with Moderate Growth and Debt
• The Great Game?
• Table 7-3: Repurchase Effects with Rising Debt: “Slo-Mo LBO”
• Remedying Issues with Pre-Tax Income, Net Income, EPS and ROE
• Cash Flow Metrics
• The Big Choice
• Endnotes

Chapter 8: Value-Based Performance Measures
• Value-Based Measurement
• Value-Based Metrics
• Figure 8-1: DCF Valuation and Value-Based Metrics
• Economic Profit (EP) or Economic Value Added
• Use the Metric, Lose the Rest
• Total Business Return (TBR)
• Shareholder Value Added (SVA)
• Cash Value Added (CVA)
• Cash Flow Return on Investment (CFROI)
• Real Value Added (RVA)
• Common Values
• Table 8-1: Present Value Equivalency of DCF, EP, CVA and RVA
• Table 8-2: Present Value Equivalency of DCF, SVA and TBR
• What If You Held a War and Nobody Came?
• What About All the Stuff that Comes with the Metric?
• Metric Adjustments — Compulsories Only
• Risk-Based Capital Requirements and Return on Economic Capital
• How Not to Choose Among Value-Based Metrics
• Figure 8-2: Metric Fallacies
• Scope and Purpose for Value-Based Metrics
• Endnotes

Chapter 9: Ownership, Not Gamesmanship: Setting Targets and Ranges for Performance-Based Plans
• Target-Setting Norms
• Take Account of Investors, Create Clear Line of Sight
• Gamesmanship vs. Ownership
• Setting Targets Based Upon Shareholder Expectations
• Figure 9-1: Valuing a Business
• Figure 9-2: Measuring Shareholder Expectations
• Figure 9-3: DCF Analysis of Homer’s Business Unit
• Bulls Make Money. Bears Make Money. Pigs Get Slaughtered.
• Don’t Sweat the Small Stuff
• Setting Targets Based Upon Total Business Return
• Figure 9-4: TBR and Target Setting — Factors Potentially Driving Targets
• Figure 9-5: TBR and Target Setting — Treatment of Driving Factors
• Figure 9-6: TBR and Target Setting — Addressing Growth’s Effects
• Figure 9-7: TBR and Target Setting — Factors Not Driving Targets
• Dodging the Issue
• Figure 9-8: S-Curve Payout Curve
• Range and Domain: Setting Intervals for Performance and Pay
• Figure 9-9: Historical EBIT vs. Trend (Regression)
• Figure 9-10: Distribution of Operating Performance Based on Industry Standard Error of Trend
• Prerogatives of Rank
• Figure 9-11: Cross-Sectional Variance Effects
• Games without Frontiers: Placing Limits on Performance Ranges
• Weightings, Award Leverage, Influence and Testing the Plan
• Endnotes

Chapter 10: Business Units and Private Companies, Phantom Stock and Performance Plans
• Why Haven’t Companies Already Fixed This Problem?
• Private Companies
• Phantom Stock and Subsidiary Equity
• TBR Phantom Stock Plan Example
• Figure 10-1: Phantom Stock Grant — Three-Year Example
• TBR Phantom Stock Grant Term, Frequency and Vesting
• TBR Phantom Stock Grant Structure and Leverage
• Figure 10-2: Setting Leverage — TBR Example
• Dilution Guidelines and Competitive Award Levels
• Valuation Approaches for the Phantom Stock Plan
• Market Valuation Techniques
• Discounts for Lack of Marketability and Control
• Valuation Accuracy vs. Incentive Efficacy
• Reconciling Market Value and Formula Value
• Formulas, Funding and Fiscal Fears
• Market-Indexed and Performance-Based Valuation Formulas
• Figure 10-3: TBR and Incentive Design — Phantom Stock Based Upon P/E Ratio
• Combining Performance Valuation and Indexed Valuation
• Figure 10-4: Internet Company Valuation Formula Example
• EBITDA as a Valuation Yardstick
• Equity-Based Incentive Plans Based Upon Book Value
• Anti-Dilution Features
• Adjusting Valuation Results
• Performance Plans
- Value-Based Incentives vs. Performance Plans
- Phantom Stock vs. Performance Plans
• Value Rules vs. Private Equity Incentive Structures
• Summary
• Endnotes

Chapter 11: Using Stock to Build Effective Incentives
• What Is It Good For?
• Good Hedges Make Good Neighbors
• Good Trades vs. Bad Trades
• A Firm Grip, or White Knuckles?
• Executive Ownership Is Not About the Company Owning the Executive
• Table 11-1: Stock Ownership Guidelines
• Is Time on Your Side?
• Who’s Who
• Stock as a Problem-Solving Device?
• Last Things First
• Ownership with a Capital ‘O’
• Magic Tricks?
• The Rulebooks Are Changing
• How to Choose
• Performance Shares Earned Based Upon Operating Goals
• Indexed and Peer-Based Grants
• Stock Options with Premium, Discounted or Rising Exercise Prices
• Summary
• Endnotes

Chapter 12: The Medium Is the Message
• Value Rules from Finance’s Perspective
• Value Rules from HR’s Perspective
• Design Process
• Flexibility, Stability and Plausibility
• Rollout, Communication and Training
• Bottom Lines

Glossary

Index