CFO Corner: Beyond TSR (Total Shareholder Return)

Dan Walter, Performensation

Executive
Pay that Works for Shareholders and Companies

Like
Milli Vanilli in 1990, Total Shareholder Return (TSR) is currently all the rage
in executive compensation plans. And, like Milli Vanilli, as entertaining as
TSR is to some, it may prove to be a less than stellar performer for most. Of
course, unlike the disgraced pop-stars, TSR is unlikely to disappear from view
any time soon.

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What
is TSR? 

It is the growth or shrinkage in stock price plus any dividends paid to
shareholders. For many shareholders, this is the single most important
measurement of how a stock performs against both expectations and peers. It is
important to remember that TSR is a result of actions, not the driver of
actions. Results are fantastic because they align with accountability. Drivers
are critical because they are what lead to results. As a standalone executive
compensation metric TSR is good, but its much stronger when combined with other
metrics.

Given
its ubiquitous use by investors, it is not a shock that it has become the “go
to” metric for long-term Pay for Performance (P4P) programs. Say on Pay has
lead to an explosion of P4P programs and TSR has quickly become a darling of
the consulting crowd. TSR has real value as a metric. But, it may prove to be a
less than an ideal goal or modifier of compensation. And, once you include time
as an element, you have the ingredients for either a great program or a
disaster.

Understanding Metrics and Goals

Metrics
are the things you measure. Goals are the triggers or numbers associated with
the metric. In some specific cases, the metric and the goal can be the same
item. This is true in the case of a
Change in Control. Goals can either be thresholds or modifiers. A threshold
goal is an on/off switch. A modifier can increase or decrease the amount
originally targeted for payout. Any metric can be structured to serve either
goal purpose, but some work better than others in either role.

Relative-TSR 

When
companies use TSR as a modifier, they generally use a Relative-TSR (R-TSR)
metric (your TSR compared to a peer group). This requires a careful and honest
selection of peers. Once you have your peers you must determine where your
company fits into the group today and where it should fit over the life of an
award. Your compensation philosophy and structure should help decide the target
award level. With this as a foundation, your modifiers will define a scale of
how much more or less (if any) than the target will be received based on your
ranking within the peer group. Since R-TSR simply measures your company’s
success by how it performs compared to your peers, you pay huge rewards even if
you are the only company to stagger onto the beach after a terrible market
shipwreck. You may end up paying out at the top tier while your shareholders simmer
and your employees are laid off.

TSR as a Threshold Goal

Now
consider TSR or R-TSR as a threshold goal. You may have a very good idea of the
absolute TSR that is acceptable to your shareholders. Or, you may know
generally where you need to fit into the pack to be considered a good
investment. You can use this knowledge to use TSR as a threshold goal. For
example: 3 year absolute TSR must be at
least 12% or R-TSR must be above the 65^th percentile in our peer
group. Obviously, these are cleaner and easier goals to communicate and
operate, but alone they deliver no value to your executives. It is unlikely you
want to use an all or nothing switch for your executives’ long-term incentives.

Combining Metrics

When
using TSR or R-TSR as a threshold, you should combine it with another metric
linked to a modifier goal. Common metrics for this purpose include revenue,
profit and EBITDA. But, the great thing about your modifier metric and goals is
that you can focus your executives on the aspects of your business that drive
TSR. Combining TSR and internal metrics allows you to meet the needs of your
shareholders. Like a lip-syncing pop star, TSR may prove to be less than you
expected. Before you finalize your decisions on metrics consider a more nuanced
approach to your executive compensation programs.

TIP:
If you are using TSR or some other performance metric in your programs you
might want to take a look at the following document on how to better communicate these programs.