Pay Check
Does Michael Dell’s salary compute? Is Dick Cheney’s bonus defensible? Are Herb Kelleher’s stock options on course? We analyze the earnings of twenty Texas CEOs: Who’s underpaid, who’s overpaid, and who’s on the money?
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I’VE BEEN IN THE EXECUTIVE COMPENSATION business for 39 years. For the first 28 years I designed incentive plans for CEOs and other senior executives around the world; for the past 11 I’ve critiqued such plans as a university professor and as the author of six books and hundreds of articles on executive pay. And in all that time, I’ve rarely come across a corporate chief as undeserving of his pay as Lester M. Alberthal, Jr., who is about to retire as the CEO of Plano-based Electronic Data Systems. Alberthal fits the mold of a classic pay abuser. Although his performance was just plain terrible most of the time, EDS’s board lavished upon him vast sums of money: a total compensation package worth more than $13.8 million in 1997. Yet you’d have to search long and hard during Alberthal’s nearly twelve years as CEO to find an instance when EDS outperformed the Standard & Poor’s 500 Index, a listing of five hundred stocks that is the premier gauge of the stock market. Actually, there is one instance that springs to mind, and that was August 7, 1998, the day after EDS announced his retirement. That day the company’s stock price jumped 14 percent, adding $2.5 billion to the total market value of the stock. It’s not often that a CEO can determine just how much impact he personally is having on his company’s stock price, but for Alberthal, August 7 was one for the books.
Fortunately, not every head of a corporation is a pay abuser, as I discovered when I analyzed the compensation of twenty Texas CEOs. In fact, although the state is often described with superlatives, the men who run its best-known companies are wimpy when it comes to executive pay. In 1997 the typical Texas CEO delivered a shareholder return (stock price appreciation and reinvested dividends) in periods of three, two, and one fiscal years that was essentially average when compared to the return delivered by CEOs around the country. Nonetheless, he earned a base salary that was 7 percent below the market, a combination of base salary and annual bonus that was 17 percent below the market, and total compensation (salary, bonus, miscellaneous compensation, and long-term incentives, including the estimated present value of stock-option grants) that was 30 percent below the market.
How did I arrive at these and other conclusions? What exactly is “the market”? To assess whether a CEO is paid too little, too much, or just enough, you can’t simply tote up the average pay of other CEOs and then compare it to his. In a study I completed a few months ago, I found that the average total compensation for 279 CEOs across the country was $8.7 million. But the range varied wildly, from $100,000 for Warren Buffett of Berkshire Hathaway to $152 million for Sanford I. Weill of Travelers Group. So, for each CEO, I adjusted for three factors:
•COMPANY SIZE Other things being equal, CEOs of large companies are paid more than CEOs of small companies. In determining company size, I gave equal weight to the company’s 1997 revenues and to its year-end permanent capital in the business—that is, the sum of long-term debt and shareholders’ equity.
•COMPANY PERFORMANCE There are, of course, numerous ways to look at company performance, but I focused on the one thing shareholders look at the most: total shareholder return. At the end of the day, that’s what shareholders care the most about, much more than growth in earnings per share and return on equity. Because a company can look good or bad at any given time, I measured total shareholder return for the 1997 fiscal year, the 1996 and 1997 fiscal years combined, and for the 1995, 1996, and 1997 fiscal years combined. Then I constructed an overall performance score for the company by giving three times the weight to the three-year period and two times the weight to the two-year period.
•TYPE OF INDUSTRY Surprisingly, the industry in which a CEO works has little bearing on his pay if differences in company size and performance are taken into account. I found that only one industry paid differently than other industries: the utility industry, which pays its CEOs significantly less than nonregulated companies pay their CEOs. (By contrast, the Baby Bells, though they are still highly regulated, do not require their CEOs to wear compensation hair shirts. They pay them competitively, thank you very much.)
After weighing these factors, I considered the many elements that make up a CEO’s pay package. Leaving aside broad-based fringe benefits like pension plans and medical insurance, they can be boiled down to base salary, annual bonus, and long-term incentives. While the first two are self-explanatory, the third, alas, is not. Long-term incentives are designed to induce a CEO to focus on the company’s performance over time. They come in three basic flavors:
•STOCK OPTIONS Options are far and away the most popular long-term incentive. The CEO is given the right, but not the obligation, to buy a number of shares of his company’s stock for a fixed period of time at a fixed price. If the stock price rises, he makes out—but if it doesn’t, he doesn’t lose because he doesn’t have to exercise the option.
•RESTRICTED STOCK Here the CEO is given a number shares. To earn them, he need do nothing more than breathe while he is on his company’s payroll for, say, five years.
•PERFORMANCE PLANS A few companies offer their CEO large sums of cash for meeting predetermined performance goals. Or, instead of cash, the CEO is given a number of shares, though in contrast to restricted stock grants, his performance must meet certain expectations before he is permitted to take possession of the shares.
Sounds simple, right? Not so fast. Whenever you attempt to calculate total compensation, there always arises the thorny issue of how to value stock options. My preference is to answer the following question: If the CEO, on the date the option is granted, were free to sell it to an outside party, what might that outside party pay for the privilege of having a long-term call on the stock? CEOs like to tell you that it is impossible to value an option on the date it is granted because it’s impossible to know what the future holds for the stock price. Indeed, they would have you believe that the option is worthless on the date it is granted, because the price the CEO has to pay to exercise the option is equal to the market price of the stock on the date of the grant. Therefore, the CEO points out, there is no gain at the time of the grant, and since there is no gain—voilà!—the option must be worth nothing. But if options are worth nothing, why is it that CEOs would crawl through fire to get them? The fact is, an option can be valued at the time of its grant, though different analysts have different methods of doing it. I use a modified version of the Black-Scholes Option Pricing Model, which was formulated by economists Fischer Black and Nobel prize—winner Myron Scholes and carries the seal of approval of the Financial Accounting Standards Board (the regulatory body for accounting in the U.S.) and the Securities and Exchange Commission.
All that said, I’ve assigned one of four labels to each of the twenty CEOs on these pages:
•WORTH IT BIG TIME CEOs in this category generally are excellent performers. Some earn substandard amounts of pay, making them incredible buys. Others play the pay game so fairly that you have to give them credit. A few performed so magnificently that I overlooked the fact that they earned far more than the norm.
•WORTH IT A CEO in this category will have more or less normal performance and more or less normal pay. However, a CEO who turned in a substandard performance and received substandard pay could also fit here. It may seem counterintuitive to view a low-performing, low-paid CEO as worth it, but if someone didn’t perform below the average, the average wouldn’t be the average.
•NOT WORTH IT Here we have a CEO who typically combines substandard performance with pay that, though perhaps not out of sight, is too high in relation to his company’s size, performance, and type of industry.
•NOT WORTH IT BIG TIME CEOs in this category are lousy performers who insist on being paid as if they were terrific performers. This utter disconnect between pay and performance is what gives them this bottom-rung ranking.
Lester M. Alberthal, Jr.
Electronic Data Systems — Plano
Base salary $850,000
Salary plus bonus $850,000
Total compensation $13,844,000
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