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The New Standards: Methods for Linking Business Performance and Executive Incentive Pay

ISBN: 978-0-470-55989-5
336 pages
April 2010
The New Standards: Methods for Linking Business Performance and Executive Incentive Pay (0470559896) cover image
Make the most of the new standards

Every year companies spend millions of dollars on executive incentives. All too often, however, these programs provide a very weak link between pay and performance, with executives potentially rewarded as much for bad decisions as they are for good ones.

Packed with examples, The New Standards insightfully discusses:

  • How to link pay with business results that create long-term value

  • Why incentive structures can discourage management from reasonable risk-taking, in some cases, and can enocourage imprudent risks in others

  • The full range of inputs that should guide proper incentive policy

  • Why performance measures must reflect both the quality and quantity of earnings

  • Risk, executive behavior, and the cost of capital

  • How to use valuation criteria when choosing metrics

  • The pros and cons of common approaches to stock-based incentive pay

Written by noted compensation expert Richard Ericson, this innovative book is a must-read for directors and management concerned with executive compensation design or financial performance measurement and forecasting. Get the guidance and concrete solutions you need to thoroughly reexamine your executive compensation policies and practices with the principles and financial maxims found in The New Standards.

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Preface.

Acknowledgements.

Chapter 1 To the CEO.

Well-Designed Incentives Are Governance Defined.

Old School.

Act Now.

You Do Not Run Your Company.

The New Standards.

It Is Not About You.

Last Things First.

Bottom Lines.

Chapter 2 Business Valuation and Incentive Policy.

The Rosetta Stone.

Stealing the Playbook of Business Valuation.

Incentives and Value Creation.

Value Is a Function of the Quality and Quantity of Earnings.

Cost of Capital and Expected Returns.

As Long as We're at It.

What Are We Paying For?

Total Business Return.

The DCF Model Serves as a Proxy for Other Valuation Methods.

Free Cash Flow.

FCF and the Irrelevance of Accounting Choices.

Income and Capital: FCF’s Drivers Should Be the Main Incentive Drivers.

The Shape of Things to Come.

Quando, Quando, Quando.

The Past Is Relevant Only as Prologue.

Valuation Perspective: Operational Results, Debt, and Capital Structure.

Chapter 3 Market Practices in Incentive Pay.

How Much Are We Paying for Management Incentives?

Variable Pay versus Incentive Pay.

Mismatch Makers

Other Market-Based Considerations of Market-Based Consideration.

Market Practices and Presumptions.

Chapter 4 The New Standards.

Common Sense.

Bias Is the Boll Weevil of Value Creation.

Get Cynical.

Incentivization and Its Discontents.

Leading Charcter.

Guidelines for Incentive Design.

Chapter 5 Risk and Executive Incentive Pay.

Risk Management Policy and Incentives.

Sheep in Wolves' in Clothing.

Investors versus Management.

The Risk Trade.

Risk and Incentive Calibration.

The Wages of Risk: Estimating the Cost of Capital.

Beta Coefficients and the Capital Asset Pricing Model.

Financial Leverage and the Cost of Capital.

Other Methods and Evidence for Attaching a Cost to Capital.

Chapter 6 Motive, Means, and Method:  Evaluating Incentive Performance Metrics.

Role of Individual Performance in Incentive Pay.

Nonfinancial Goals.

Evaluating Financial Metrics.

Revenue, Volume, and Gross Margin.

Using Valuation Criteria to Choose Metrics.

Context for Evaluating Financial Metrics.

Operating Income, EBIT, and Return on Invested Capital.

Two Wrongs Can Make a Right.

On the Importance of Being Earnest.

Pretax Income, Net Income, EPS, and ROE.

Debt, Share Repurchases, EPS, and Stock Price Gains.

Remedying Issues with Pre-tax Income, Net Income, EPS, and ROE.

Cash Flow Metrics.

Indexation and Immunity.

Overall Perspectives.

Chapter 7 Value-Based Performance Measures.

Value-Based Measurement.

Economic Profit or Economic Value Added.

Use the Metric, Lose the Rest.

Total Business Return.

Shareholder Value Added.

Cash Value Added.

Cash Flow Return on Investment.

Real Value Added.

Common Values.

Metric Adjustments and Business Governance. 

Metric Adjustments: Compulsories Only.

Risk-Based Capital Requirements and Return on Economic Capital.

How Not to Choose Among Value-Based Metrics.

Scope and Purpose for Value-Based Metrics.

Chapter 8 Ownership, Not Gamesmanship: Setting Targets and Ranges for Performance-Based Plans.

Best of Both Worlds.

Trifold Guide to Benchmarks.

The Past Is Prologue.

Not to Insult Chimpanzees.

Interpreting the Oracle.

Multiple Personalities.

Full Reconciliation of Market Value.

Setting Targets Based on Total Business Return.

Run Away!

Range and Domain: Setting Intervals for Performance and Pay.

Weightings, Award Leverage, and Participant Influence.

Incentive Risks, Calibration and Testing.

Chapter 9 Business Units and Private Companies, Phantom Stock, and Performance Plans.

Private Companies.

Phantom Stock and Subsidiary Equity.

Phantom Stock Plan Example Using Total Business Return.

TBR Phantom Stock Grant Structure and Leverage.

Dilution Guidelines and Competitive Award Levels.

Valuation Approaches for the Phantom Stock Plan.

Market Valuation Techniques.

Discounts for Lack of Marketability and Control.

Valuation Accuracy versus Incentive Efficacy.

Reconciling Market Value and Formula Value.

Market-Indexed and Performance-Based Valuation Formulas.

EBITDA as a Valuation Yardstick.

Equity-Based Incentive Plans Based on Book Value.

Tale of Three Cities.

Adjusting Valuation Results.

Performance Plans.

Value-Based Incentives versus Private Equity Incentives.

Where the Rubber Hits the Rod.

Chapter 10 Using Stock to Create Effective Incentives.

From the Top.

Off to the Races.

Pros and Cons of Major Approaches to Stock-Based Incentive Design.

All-In-One.

Let Them Eat Risk.

Purely Stock-Based LTI Approaches.

Keeping the Horses in the Barn.

Granting and Leverage.

Equity-Based Incentives in Venture-Stage Companies.

Ownership Effects.

A Whole New Ball Game.

Chapter 11 The Medium Is the Message.

Incentives and Financial Governance.

Human Resources Perspectives.

Glossary.

Index.

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Richard N. Ericson is an expert in executive compensation with Towers Watson. He has more than twenty-five years of experience in business valuation, performance standard setting, incentive design, and general executive pay consulting. Mr. Ericson holds an M.B.A. in finance from the University of Chicago.
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