Page 138 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

124 The Complete Guide to Executive Compensation

appreciation. This is sometimes expressed as a quantitative benchmark called the equity
premium. An equity premium is the additional return (dividends plus stock-price apprecia-
tion) over a risk-free investment such as U.S. Treasury bonds. Historically, this has averaged
around 6 percent. Even with federal treasuries, one can do an after-tax comparison to
municipal bonds (often called munis) that are not subject to federal income tax. Thus,
a person in a 50 percent marginal tax bracket would have a 3 percent after-tax return on a
6 percent federal treasury, but a 4 percent after-tax return on a 4 percent muni.
Stocks are often described as either a growth or value stock. A growth stock is one with a low
dividend (and therefore low yield) because the stock price is expected to increase faster than
the average of other prices. It is probably in the growth stage of the market cycle. Conversely,
a value stock is one with a high yield because of depressed stock prices, which hopefully will
rise, or it is in the mature stage of the market cycle, hoping for a return to the growth stage.
A rise in shareholder value (i.e., dividends plus stock price) and/or a drop in risk-free
interest rates would move investors to the stock market. Similarly, a decrease in the expected
equity premium might provoke moves in the opposite direction, with investors moving from
equity markets to risk-free investments. Few companies could expect to retain a shareholder
without meeting his or her return expectations, although high scores for innovation and social
responsibility might help. Another comparison that investors examine is the relationship of
book value to market value. When book value exceeds market price, takeover specialists are
attracted to buying the stock to gain control of a company and then sell off the assets. In the
process of acquiring control, they have taken on large amounts of debt. Cash flow becomes
critical to meet interest payments, which puts a restraint on investment opportunities. Expense
control is critical. Typically, annual incentives focus on return on invested capital, whereas
long-term incentives look to shareholder value.
Some investors are particularly interested in the quality of earnings (i.e., those resulting
from revenue, not tax write-offs), the use of corporate assets, and the strength of the balance
sheet. These are the items of most interest to shareholders, not recipients of executive
compensation. Nonetheless, resolutions may be put before shareholders to alter the design
of pay plans and/or limit payments to the CEO and other executives. Typically, as long as the
shareholder is prospering, such resolutions are unlikely, which is not the case when CEOs are
prospering and the stock is languishing. The ability, or lack thereof, of an organization to
attract, develop, motivate, and retain people of talent, especially in management and other
key roles, has a strong correlation with success.
Investors are usually interested in companies that have a recent history of stock splits, where
the price per share is proportionately reduced by the number of shares increased. For example,
a share of stock selling at $100 a share will be selling at $50 a share after a two-for-one stock
split, but the total value of stock held is still $100 because each share is worth $50. The reason
companies do stock splits (and attract investor interest) is that they are confident the stock price
will continue to rise, and without periodic stock splits, the shares would be selling at thousands
of dollars each. This would not affect institutional purchases but would limit purchases by the
individual investor with a limited asset position. A reverse stock split is the opposite of a regular
stock split. For example, if the stock was selling for $5 a share, the company might decide to do
a one-for-three split, giving each shareholder one share for every three, hoping the stock price
would rise to at least $15 a share. Reverse splits are done because the stock appears to be cheap.
As the stock price gets close to a $1 share, companies do reverse splits so as not to fall below a
minimum price level set by the stock exchange (typically $1 a share).