Metric Selection and Goal Setting: The Keys to Incentive Plans. Mike Halloran

Transcription

1 Metric Selection and Goal Setting: The Keys to Incentive Plans Mike Halloran

2 Three macro areas related to design issues Performance Measure Selection How do we measure success? Target-Setting What does good performance look like? Pay-for-Performance Calibration How much should we pay for a given level of performance?

3 Performance Metric Selection

4 The challenge faced by companies is re-thinking pay-forperformance Sure, we have a very strong payfor-performance relationship... but how do we know that we re paying for the right performance? And the right amount of performance?

5 Performance measurement, linked to compensation, is an integral part of the framework for creating shareholder value Examples Goal Shareholder Value Creation Exceed median peer TSR Double value in 5 years Strategy Roadmap to Achieving Goal Penetrate markets Develop new products Performance Measurement Management Processes (including compensation) Operating Decisions Integrated Program to Support Company Goal and Strategy Revenue Growth Return on Total Capital Economic Value Incentive determination process Consistency with planning, budgeting and financial reporting processes Inventory Turns Customer Retention New Product Revenue

6 Caution: Conflicting signals will get in the way of value creation Long-Range Planning Measure: Discounted Cash Flow (DCF) Goal: Maximize DCF subject to a threshold return Signal: Invest in every project over the threshold return Annual Incentive Plan Measure: Return on Net Assets (RONA) Goal: Maximize RONA for maximum cash bonus Signal: Invest only in projects with high nearterm RONA; avoid new capital investments

7 Getting the measurement system right is critical Poor Alignment/Line-of-Sight Managers get conflicting signals from incentive compensation and other information systems Capital investments are misdirected, wasting shareholders money Stock price performance suffers Strong Alignment/Line-of-Sight Management decision-making is improved; incentives and information systems provide clarity Capital investment is disciplined, optimizing the use of shareholders money Stock price performance benefits A basic understanding of financial statements is necessary prior to the selection of the right performance measure for a firm

8 The unique character of each business drives the need for more (or less) information and measure complexity Measurement Matrix High Gross Margin Net Income Growth Margin % ROIC/ROCE ROE ROA Low Revenue Growth Product Development/ Roll-out Revenue Growth Earnings Growth Early Mature Stage of Development/ Industry Context

9 Sample Performance Metrics by Industry and/or Growth Stage Industry / Growth Stage Sample Metrics Considerations Start-Ups Manufacturing Services Retail Hotels Revenue growth Profit margins (usually less emphasis) Strategic metrics ROIC Operating cash flow Profit margins Inventory or asset turns Revenue growth Profit margins or growth Same store revenue growth Total revenue growth Profit margins ROIC Efficiency metrics (e.g., revenue per available room) Customer satisfaction Building scale or taking market share with rapid growth is usually most critical Profits are important, but may come later Efficient management of capital is often most critical Competitive advantage derived from doing more with less Very little capital investment Revenue and profit growth indicate market success and ability to expand offerings or take share Different revenue metrics indicates organic or expansionary success Margins ensure profitable growth Capital efficiency is critical due to large investments Efficiency is daily measure of success Customer satisfaction is leading indicator of future revenue

10 Performance Metric Definitions Alternative Performance Measures Measure Definition Info Added Pros Cons Sales Growth Revenue Generated, Net of Discounts & Returns Volume and Price Motivates increasing market penetration Simple Volume is the primary goal Does not consider expenses and capital costs Operating Profit Revenue - OPEX Operating costs Focuses on core business operations and profitability Simple Ignores capital costs Could ignore important non-operating expenses/revenues Net Income Net Income (1) Non-operating costs Focuses on total earnings of company Simple Quality of earnings is not considered Distorted by non-recurring accounting costs Ignores capital costs ROA Net Income (1) Avg. (Total Assets Current Liabilities) Assets Focuses on asset management Simple Motivates asset base minimization Distorts assets (uses original bookpurchase) Does not encourage sufficient growth focus ROIC Net Income (1) Avg. (Equity + LT Debt) Capital Measures return on total investment More difficult to manipulate Somewhat simple Motivates investment minimization Distorts capital (uses original bookpurchase) Does not encourage sufficient growth focus EVA NOPAT (Net Assets x WACC) Risk Focuses on growth and returns Removes many accounting distortions Captures cost of capital Dependent on cost of capital More complex TSR Stock Price Appreciation Plus Reinvested Dividends Market expectations Tied directly to shareholder value creation over the long-term Dependent on external market forces (1) Often before extraordinary items and discontinued operations

11 Target-Setting/ Pay-for-Performance Calibration

12 Effective performance goals must be achievable, yet meaningful Achievable Reasonable given current market environment Perceived by participants as attainable, especially at threshold Meaningful Aligned with shareholder value creation expectations Sufficient stretch (especially for upside rewards) Sustainable over time

13 Goal-Setting Framework Inputs Internal Perspectives: Companies put together annual forecasts/budgets for the upcoming year. In addition, the company s management team and Board of Directors may also have an opinion about where goals should be set for the year. Consideration should also be given to the company s historical performance. These are typically the primary sources that are considered when setting goals. External Perspectives: In addition to the considerations above, it is important to look at the performance of the company s peer group, broader industry/market performance, and analyst expectations This combination of both internal and external perspectives provides a balanced view on performance goal-setting, and mitigates the risk of setting goals that could be perceived as too conservative or too aggressive. INTERNAL PERSPECTIVES Internal Forecasts Management & BoD Opinion Historical Performance Performance Goals Peer Group Historical Performance Broader Industry/ Market Historical Performance Equity Analyst Estimates EXTERNAL PERSPECTIVES

14 Goal-Setting Framework When considering historical performance, a frequency analysis is conducted, typically over the last 10 years if available, but no fewer than 5 years. The analysis is based on the following typical risk profiles for each level of performance, Threshold: a level that has been achieved no less than 80%-90% of the time Target: a level that has been achieved in approximately 50%-60% of the time Maximum: a level that has been achieved no more than 10%-20% of the time Note: Profiles above may be adjusted based on the payout level associated with that level of performance (e.g., max may be set at 5%-10% profile if max payout is >200% of target) Example % of Time Achieved in Last 10 Years 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% Client Peer Group Broader Industry Group Threshold: Achieved 80%-90% of the time Target: Achieved 50%-60% of the time Maximum: Achieved 10%-20% of the time 0% -5% 0% 5% 10% 15% 20% 25% ROIC

15 Another perspective for setting performance targets and ranges is direct peer comparisons 12.0% 11.2% ROGA % 10.0% 8.0% 6.0% Threshold 5.5% 5.1% 5.2% 5.5% 6.3% Target 6.5% 6.6% Outstanding 7.5% 6.8% 7.4% 8.2% 4.0% 2.0% 0.0% 10th 20th 30th 40th 50th 60th 70th 80th 90th Percentile of Peers

16 In addition to direct analysis, analyst reports and earnings or cash flow forecasts are also an important source of information regarding expectations 40% Analyst Expectations Mean Earnings Growth Estimates ABC vs. Peers Growth in Earnings Estimates 35% 30% 25% 20% 15% 10% 5% 33.5% 16.7% 15.9% 15.4% 13.3% 12.0% 11.7% 11.4% 10.4% Median = 13.3% 14.2% 0% 0.7%

17 Finally, testing the performance required on other dimensions to achieve target performance levels can be revealing What revenue growth and margin are needed to achieve a $0.39 EPS target? Net Margin Projected EPS Given Revenue Growth and Operating Margin Revenue Growth -10% -5% 0% 5% 10% 15% 20% 10% $0.47 $0.50 $0.53 $0.55 $0.58 $0.60 $0.63 9% $0.43 $0.45 $0.47 $0.50 $0.52 $0.54 $0.57 8% $0.38 $0.40 $0.42 $0.44 $0.46 $0.48 $0.51 7% $0.33 $0.35 $0.37 $0.39 $0.41 $0.42 $0.44 6% $0.28 $0.30 $0.32 $0.33 $0.35 $0.36 $0.38 5% $0.24 $0.25 $0.26 $0.28 $0.29 $0.30 $0.32 4% $0.19 $0.20 $0.21 $0.22 $0.23 $0.24 $0.25 7% Net Margin is aggressive relative to Company s trailing four quarters (+3%), but reasonable relative to trailing four quarter peer median (+7%) 5% revenue growth is aggressive relative to: Company s last four quarters (+2%) Median of peers last four quarters (+1%)

18 Final Decision Points Example ROIC Goal-Setting 18% 16% Max Target Threshold 16.0% 14% 14.1% 14.5% 14.5% ROIC 12% 10% 8% 10.9% 11.0% 10.4% 12.7% 7.1% 8.9% 10.0% 11.0% 7.5% 6% 4% 6.0% 4.5% 2.8% Final Program 2% 0% Client Budget Management Opinion Client Historical Performance 0.0% Peer Group Historical Performance Broader Industry Historical Performance Analyst Estimates

19 Ultimately, multiple internal and external benchmarks need to be combined to provide an informed discussion of reasonableness Internal Perspectives Company ABC ROIC Goal-Setting External Perspectives Company Historical 15% 15% S&P th %ile 75th %ile 10% 17% 10% 17% Company Budget 12% 12% Management/BoD Opinion 13% 13% Corporate Performance Objective 15% Peer Companies 50th %ile 75th %ile 8% 12% Industry Index 50th %ile 75th %ile 15% 17%

20 Relative vs. Absolute Performance

21 Use of absolute goals The strategic/long-term plan is a natural standard Usually developed through a rigorous internal process Reviewed and approved by the Board Communicated to the organization, as a set of expectations and a rallying point Some use pre-set company standards Minimum earnings growth of 5% Average ROIC of 15% However, this approach when used for incentive purposes is easy to criticize despite good intentions Management self-interest at work Allows for payments even in poor years (absolute or relative) if budgeted Not necessarily shareholder friendly

22 Relative performance is favored by many Captures true performance using information from peer companies With the same internal business economics With the same macro economics Competing in the same products and/or markets Rewards out-performance and penalizes underperformance Alleviates much of the pressure on target setting

23 Relative goal-setting has several key requirements A viable number of peers, now and later Fewer industries qualify today The number continues to shrink Timely availability of data Better for long-term plans More difficult for short-term plans Comparable data for your metric Similar definitions, and/or Few if any required adjustments

24 However, the use of direct relative measurement has a few key conditions Potential to pay, and possibly pay well, for negative performance The ability to change if conditions change Rapid industry consolidation Sudden unavailability of data Sudden change in comparability of data If used, need to determine if the key measurement perspective is Relative performance, or Relative improvement This approach can be used For the entire program For a part of the program In a formulaic or discretionary way

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