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10 Second Takeaway

With little surprise to any investor these days, executives have been reaping some of the highest compensation packages ever seen before. This compensation comes in various forms such as cash, restricted stock, stock options, golden parachutes, pension increases, amenities, cash bonuses or some combination of the above. The essential takeaway of this article is that some forms of compensation align shareholder and management interests and others do not.

Executives who have aligned interests with shareholders are more likely to work harder to add value to a company through increasing share prices, increasing dividends, or significant share buybacks. Understanding how executives are incentivized gives illuminating insight into an executive's motivation. Before we get ahead of ourselves, let's jump into a standardized compensation analysis made to both understand executive's motivations and to make companies of various sizes comparable.

Methodology

The first step in my analysis is to find the most recent executive compensation listing, which is usually found in a company's proxy statement. There will typically be between 4-6 executives listed with their respective breakdown. Experience doing this analysis consistently has shown that 5 executives is the most commonly reported format. The next step is to add the total compensation of each of the top 5 paid executives. If there are only 4 executives listed, take the lowest executive's compensation and double it to simulate a fifth executive's compensation.

The next step is to find the company's operating income for the year you are taking the compensation from, which can be found in the 10K report or consolidated financials. The next step is to take the top 5 executives total pay and divide it by the company's operating income giving us the desired metric.

The ranges observed vary depending on the size of the company, experience of the executives, and the nature of their business. For large to mega-cap stocks, a comfortable range for executive compensation is typically between .5-1.5% of the companies operating income (the metric calculated above). Mid-cap stocks with reasonable executive compensations will often fall into the 2-3% range. Small cap stocks will fall into a 3.5-5% range and micro-cap stocks can reasonably run into the 5-6.5% range.

These are not precise figures, but serve as a valuable tool to quickly check if a company's executives are paid too much, causing a red flag. Once you do enough executive compensation analyses, you may find a more suitable range for your level of risk level. There are exceptions to these ranges that are key to understand. First, companies with very low fixed costs and with very high human capital are likely to be higher in these ranges. Asset managers, small software (DSS) and biopharmaceutical companies (QCOR), patent IT companies (ACTG), and executives who left a top-tier corporate job to start their own business or join a prospering business are all exceptions to these ranges.

Among the most notable executive compensation packages are Tim Cook of Apple(AAPL), David Simon of Simon Property Group (SPG), Larry Ellison of Oracle (ORCL), and Eric Schmidt of Google (GOOG). My compensation metric will show that David Simon is paid the most relative to Simon Property Group's operating income, despite not being paid the most in absolute terms. This is a red flag in my due diligence analysis and should be considered when purchasing the stock.

There will be a second part to this article within the next couple weeks highlighting the specific implications of each type of compensation listed above. I will rank and then explain how each compensation method effects an executive's motivation differently. The final step is to map out proper incentives for executives to create a high degree of alignment with shareholder's interests.

If you have any questions, thoughts, or want to share the results of your executive compensation analyses please feel free to share in the comment box. This methodology has served me well in the past and is an important way to distinguish your due diligence process.

Market Capitalization Classification

Mega Cap - Market cap of $200 billion and greater
Big Cap - $10 billion and greater
Mid Cap - $2 billion to $10 billion
Small Cap - $300 million to $2 billion
Micro Cap - $50 million to $300 million
Nano Cap - Under $50 million

Market Cap definitions found here

Source: How Executive Compensation Drives Corporate Motivation