The story that Canada’s 100 highest paid CEO’s earn 155 times as much as the average worker has got legs. On Tuesday, the Toronto Star carried an editorial invoking CEO pay to support a hike in capital gains taxes for stock options. The same day, Kelly McParland in the National Post sought to dismiss the report from the Canadian Centre for Policy Alternatives, as being driven by left-wing political activism. Then yesterday, John Moore, a talk show host on CFRB in Toronto, called CEO compensation a “shakedown”. And in today’s Financial Post, William Watson offers a history lesson, pointing out that previous attempts to address CEO pay have backfired and led to the very situation being decried today.
I have already commented on the CEO pay report in an earlier blog. But a couple more points need to be made against the critics of executive compensation.
First of all, why is it that no one complains about the enormous sums earned by professional athletes, actors, musicians, or television personalities? Didn’t they also make it through the recession unscathed? Couldn’t we also isolate the best-paid among this group and find that the ratio of their earnings to that of the average worker is over 100, if not in some cases higher than the 155 figure for CEO’s?
Perhaps CEO’s are being singled out because it is felt that they don’t deserve their pay packets as much as Lady Gaga, Sidney Crosby, or Oprah Winfrey. Well then, let’s consider the main driver of high CEO pay: stock options. The options that CEO’s receive fall under the category of call options. These are rights to buy a stock at or by a future date at a set price. Because the price for the shares is set at the time the options are acquired, the right to buy becomes more valuable the more the stock price rises. As such, options tie a CEO’s performance to the company’s stock.
This is a perfectly rational way to go about compensating a CEO. A good CEO, after all, is one who raises the value of their company. This value, in turn, is equal to what individuals in the marketplace would be willing to pay in order to buy the company. In the case of publicly traded firms, this willingness is expressed in the stock market. So if the market bids up the prices of a firm’s shares during a particular CEO’s tenure, then that’s an indication that he or she has done their job well.
The report from the Canadian Centre for Policy Alternatives rejects this on the grounds that stock prices are nothing more than bets on the future performance of a company, rather than a register of past results. Instead, the think tank approvingly cites Roger Martin, the dean of the Rotman School of Business, who proposes that compensation be based on accounting measures such as revenue, profits, and return on equity.
But markets do factor in the past, insofar as it indicates something about the dividends to be paid out in the future. A stock price is equal to the present (discounted) value of the company’s future dividends. One need only witness how a stock typically moves after the release of an earnings report to see how the past matters. Also, accounting measures are easier for a CEO to massage in their favor than the firm’s stock price.
True enough, CEO’s can also impact the stock price, not just by exploiting the leeway in accounting rules, but by undertaking and talking up risk, potentially high return, projects. But this just means that corporate boards need to ensure that CEO’s wait a certain time before being able to cash out. For though stock prices might deviate from reasonable valuations in the short-run, they eventually adjust to reality.
