While total shareholder return (TSR) remains the single most common performance measure used in executive incentive plans — and long-term incentive plans in particular — its use has evolved significantly over time and has become more nuanced and sophisticated. However, to better understand what is happening now, and what may happen next, it may be useful to review the evolution of performance measures in incentive plans over time.
There have been a series of eras in incentive plan design and performance measurement. Each era has built on the knowledge and philosophy from prior eras. Each era was based on an understanding of performance and value creation at the time and reflected the prevalent views of executives, board members and investors. As financial sophistication and precision have evolved, so have performance measures. More detailed disclosure and investor scrutiny of pay and performance has also played a significant role.
The era of EPS. While there may have been prior eras focused on dividends as the main driver of shareholder value, compensation surveys started collecting relevant data on performance measures in the 1970s and 1980s, when earnings per share (EPS) ruled the incentive plan world. For well over a decade, EPS was far and away the most common performance metric, used by as much as 90% of publicly traded companies. The general belief at the time was that a company's EPS multiplied by its price/earnings (P/E) ratio equaled its stock price. While the math here is obvious, the sentiment at the time was that a company's P/E ratio was relatively constant over time, so an increase in EPS should yield a higher stock price. While people certainly knew at the time (and were taught in most business schools) that this was a gross simplification, it was a well-known shorthand that resulted in simple, logical goals that everyone understood. It allowed for easy comparisons across time, companies and industries.
The era of EVA. Perhaps because of the over-simplicity of EPS, but also because of the growing sophistication of investors and analysts and newly minted MBAs, sometime in the early 1990s, economic value added (EVA) and related calculations became very popular very quickly. The core concept in EVA is that companies must earn cash flow in excess of the cost of capital to create value for shareholders. The incontrovertible logic of this basic financial truth convinced many firms to at least start measuring EVA and, very often, include it as a core measure in their annual and long-term incentive plans. The problems with EVA, however, were twofold. First, it was complicated and difficult to calculate, understand and communicate for most managers. Second, it showed many companies that they were destroying value, which unfortunately made them less likely to adopt the measure in their incentive plans. Nevertheless, EVA ushered in a new era of far more sophisticated performance measurement.
The era of value drivers. While very few companies retained EVA for any significant period of time, most companies started adopting the core measures underlying EVA that were shown to drive value creation. (Side note: Those few companies that adopted EVA and used it in a consistent and disciplined way over the years and decades have performed extremely well and generated substantial shareholder value.) Increasingly, companies adopted some combination of growth, margins and return on capital in their incentive plans. These are the key value drivers underlying the EVA calculation and are much easier to calculate, measure, understand and communicate for most companies. In addition, companies at key points in their life cycle realize that some measures are more important than others in driving value, depending on how they are viewed by investors. We are still very much in the value driver era, and companies have become more and more sophisticated in fine-tuning their core value drivers and setting goals.
Era of TSR and relative TSR. TSR, and most notably TSR relative to an index or peer group, quickly became the most prominent long-term incentive performance measure in the mid-2000s. This coincided with both the death of stock options and the advent of “say on pay,” the mandatory shareholder vote on a public company's executive compensation programs. Prior to 2006, when an accounting expense was first required for options, the vast majority of companies provided the lion's share of long-term incentives in the form of stock options. However, as soon as an expense was required for options, most companies shifted the bulk of their long-term incentives into performance-based and time-based stock grants (restricted shares and performance shares). Performance shares and performance share units are earned based on performance, typically over a three-year period. Companies needed a reliable way to measure long-term performance, and many settled on relative TSR (rTSR). It was a clear measure of relative stock performance, was closely aligned with shareholder interests, and did not require difficult long-term goal-setting. With the advent of the required nonbinding vote on executive pay in 2010, rTSR became locked in as the most prevalent incentive performance measure since EPS, partly because it was seen as a “safe” measure that shareholders would likely not vote against.
Current era: Balance of rTSR and value drivers. Today's mix of short- and long-term incentive performance measures is far superior to anything we have seen over the last 30 to 40 years. Companies consistently employ a balanced mix of annual and multiyear value drivers in sophisticated ways that create dynamic tension between measures that must be achieved in unified harmony to generate value for shareholders. These are the inputs to the shareholder value equation, which managers know how to influence, and board members and investors understand and know how to interpret. At the same time, rTSR, the key output from the shareholder value equation is used in increasingly sophisticated ways as a modifier or partial payout factor that demonstrates and delivers clear alignment with shareholder interests (managers and shareholders win and lose together).
Future Eras
Where do we go from here? This is where it gets more interesting. Two key trends are clearly emerging, and two are just over the horizon.
The era of externalities. ESG has unfortunately become a bit of a cliché, a target of both overly positive and negative hype. Nevertheless, executives, boards and investors have become increasingly aware that companies create both benefits and costs that are not well-reflected in financial statements. These externalitiescan have very real, meaningful impacts on employees, communities, customers and the environment. Investors increasingly see how these externalities impact shareholder value on an individual company level, as well as across broad market segments, geographies and the larger economy. Hence, over 75% of larger U.S. companies have adopted some form of ESG measurement in their incentive plans. This percentage is even higher in the United Kingdom, Western Europe and other regions. So far, most of these measures are not very sophisticated, fine-tuned or clearly tied to business results and value creation. But every year, they are more pervasive, more specific, more tailored to each company and more quantifiable. This is not a fad. It is a true reflection of key external factors that will likely have a larger, clearer and more concrete impact on incentive plans.
The era of human capital. This is much more than the S in ESG. There is no question that management, boards and investors are far more concerned about the overall condition, well-being, productivity, creativity, diversity, engagement and performance of their people than ever before. This trend has been building for the last decade or more, but it dramatically accelerated during the pandemic and its aftermath and is still very much happening with hybrid work and its mostly unsolved challenges. Companies are and will continue to become ever more sophisticated in measuring all aspects of employee well-being. The tie between well-being and performance is theoretically obvious, but not as empirically ironclad as it needs to be. But new measures and ways of assessing the condition of the human asset are evolving every day. Human capital measures will likely become as important, specific, precise and focused as financial measures in determining incentives. They will also be key to how boards provide oversight and investors assess value.
Future state 1: The era of AI in measuring performance and setting goals. Despite the steady improvements in performance measurement and goal-setting over the last 40 years, most companies still employ a fair amount of estimation and approximation in selecting performance measures, weightings, goals and performance ranges. Some companies do engage in sophisticated predictive modeling, but the results are often far from conclusive. With the advent of more accessible predictive and generative AI applications, we may have better tools for selecting exactly the right performance measures and highly tailored payout curves. Or maybe the AI tools will tell us it's all for naught and we should base everything on relative TSR and call it a day.
Future state 2: The era of behavioral economics in incentive plans. Despite the development of an entire new field of economics, what we know about human biases and fallibilities is almost never incorporated into executive incentive design. We still operate under the assumption that executives are relatively perfect economic value maximizers, making ideal economic trade-offs. If only that were really true! Behavioral economics has just recently started to enter the executive incentive design conversation. It will be interesting and exciting to see what the combination of this new science and new AI technology will yield in ever more effective incentive design and performance measurement.