Growth Options and CEO Compensation

It is that time of year when CEO compensation is revealed and debated.  The Los Angeles Times just published its list of the 100 highest paid executives in California for 2015.  At the top of this list were co-CEOs Mark Hurd and Safra Catz of Oracle, each of whom received total compensation of $53.25 million.  A lot of money to be sure, but as most compensation analysts note, unreasonable given the impact their decisions can have on Oracle shareholders.  But if shareholder benefits are to be the basis for evaluating CEO compensation, how are shareholder benefits to be measured?

It seems like an obvious benchmark to use would be the company’s stock price performance during the year in question in relation to the overall market to and to an industry index.  Unfortunately, such a comparison is highly misleading.  To see why remember that stock markets are forward looking.  Today’s stock price depends on investor expectations of a company’s future performance.  Suppose, therefore, that company X hires the LaBron James of management.  At the time of the hiring, the stock price will jump to reflect the increase in future performance associated with having LaBron as CEO.  Assuming that in the year ahead LaBron outperforms all his competing managers as expected, the stock price over the course of the year will not beat the market and industry indexes because it already jumped at the outset.

If stock performance is not an appropriate metric, does the stock market provide any other indication of the value of CEOs to investors?  In my view, the answer is yes – the distinction between assets in place and growth options.  (See my previous post on the value of growth options.)  If most of the value of a company is due to assets in place, it means that a majority of the company’s value comes from milking currently existing products and technology.  No doubt a difficult task at a huge company, but hardly as difficult as innovating and developing new products.  If most of a value of a company is due to growth options, it means that the market has faith in the ability of the company to innovate and create new products.  What greater kudo could there be for the CEO that such a market belief?  Viewed in that light, it becomes evident how valuable certain leaders can be.  The chart below compares Oracle, Amazon and Facebook.  It shows that the growth options of Amazon and Facebook alone exceed the total market capitalization of Oracle most of which comes from assets in place.  This drives home how valuable Mr. Bezos and Mr. Zuckerberg are to their respective companies.  The innovations related to their leadership are assoicated with hundreds of billions of market value.  Nonetheless, compared to the $106.5 million paid the Mr. Hurd and Ms. Catz, Mr. Bezos, annual compensation is less than $2 million while Mr. Zuckerberg’s take home a lofty $1.  Talk about a bargain.

PIP vs. Growth Options_A F O

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About the Author

Prof. Bradford Cornell, Cornell Capital Group
Bradford Cornell is an emeritus Professor of Financial Economics at the Anderson School of Management at UCLA. Prof. Cornell has taught courses on Applied Corporate Finance, Investment Banking, and Corporate Valuation. He is currently developing a new course on Energy, Climate Change and Finance. Professor Cornell received his Masters degree in Statistics and his PhD in Financial Economics from Stanford University. In his academic capacity, Professor Cornell has published more than 125 articles on a wide variety of topics in applied finance, particularly empirical analysis of asset pricing models. He is also the author of Corporate Valuation: Tools for Effective Appraisal and Decision Making, published by Business One Irwin, The Equity Risk Premium and the Long-Run Future of the Stock Market, published by John Wiley and Conceptual Foundations of Investing published by John Wiley. He is a past Director and Vice-President of the Western Finance Association and a past Director of the American Finance Association. As a consultant, Professor Cornell has provided testimony and expert analysis in some of the largest and most widely publicized finance related cases in the United States. Among his clients are AT&T, Berkshire Hathaway, Bristol-Myers, Citigroup, Credit Suisse, General Motors, Goldman Sachs, Merck, Microsoft, Morgan Stanley, PG&E, Price Waterhouse, Verizon, Walt Disney and various agencies of the United States Government. Professor Cornell is also a senior advisor to Rayliant Global Investors and to the Cornell Capital Group. In both capacities, he provides advice on fundamental investment valuation. In his free time Prof. Cornell enjoys cycling and golf.