Of course, the focus has turned to outrage over Nardelli’s pay packet. And justifiably so. Wage inflation at the CEO level is outrageous, considering that aggregate profits of corporate America have grown around the historical trend the past few decades. Even the Democrats – brimming with vim and vigor and ready to storm the halls of Congress – have vowed to do something about excessive compensation.
(I sure hope they do better than when they last tried to “fix” soaring executive. Last time around, the Dems passed laws requiring companies to disclose executive compensation. The idea was based on the theory that by increasing transparency, outraged shareholders would force pay lower. However, rather than lowering compensation, increased transparency had the perverse effect of raising executive pay. Knowing what other executives earned tapped into the vanity and ego of executives who were convinced they were underpaid compared to their peers. And since boards are populated by other executives, it is no surprise that directors thought executives were underpaid. Just like they were.)
These ridiculous pay packets come out of shareholders’ hides. Fingers are rightfully being pointed at the board of Home Depot. However, two groups that also bear responsibility for this mess are the academics and compensation consultants who push the line that the stock market is efficient, and that stock prices accurately reflect all known information about the company.
Armed with theories from the brightest academic minds in finance, executives justified their pay based on the notion that since stocks are always an accurate barometer of the performance of a company, a rising stock price is evidence of sound management. Thus, any compensation earned through stock price appreciation accurately reflects executive performance.
This is nonsense. The history of the stock market is one of long periods of low returns followed by long periods of high returns. From 1966 to 1982, the market was flat even though real GDP grew around 3% per year. Does this mean that collectively, for 15 years, American management was bad? When the market began to rise in 1982, was it because management suddenly became really smart? No, of course not.
Much is being made in the press that Nardelli walked away with an ungodly amount of money while the stock price did nothing during his tenure.
Mr. Nardelli’s fall from the executive firmament was fairly stunning. In just six years, he went from being one of the most sought-after chief executives, forged in the management crucible that is General Electric, to a top target of investors outraged by his $245 million in total pay over the last five years. That amount was seen as completely at odds with the dismal performance of Home Depot stock on his watch. Yesterday, the shares closed at $41.07, almost 6 percent lower than they were the day Mr. Nardelli arrived at Home Depot in December 2000.
But is it fair to pin the blame on Home Depot's dismal stock performance on Nardelli?
Partly. Home Depot lost share to Lowe’s (NYSE:LOW), the service at Home Depot has deteriorated, the company entered into low margin businesses, the treatment of shareholders was abysmal (in particular the most recent annual meeting that lasted something like an hour where few questions were taken and no directors showed up), etc.
However, assuming that the stock price always accurately reflects the operational performance of the company is specious. In 2000, the price/earnings (NYSE:PE) ratio of Home Depot hit 99x trailing earnings, an utterly ludicrous valuation. Today, the PE on trailing earnings is 14x. Is it Nardelli’s fault he couldn’t maintain a 99x multiple on Home Depot’s stock? Was Nardelli’s management style responsible for 85 multiple points? Or did the multiple collapse because big growth stocks were in a bubble at the end of the 1990s? (A bubble that many academics, by the way, say cannot or did not happen.)
Using fiscal year end data for 2000 and 2006, diluted earnings per share for Home Depot rose from $1.00 to $2.72, sales per share rose from $17.13 to $38.12, free cash flow per share from -$0.06 to $1.22, book value per share from $5.36 to $12.67, and dividends per share from $0.11 to $0.40. No doubt, just as Home Depot’s stock was hurt by the deflating of the stock market bubble, the company’s operational performance was influenced by the inflating of the Housing Bubble.* However, the financial performance of the company was decent nonetheless.
Nardelli was grossly overpaid, but to condemn him because the stock went sideways for six years is to assume that the market is always efficient. That is wrong.
And we can thank the academics for laying the intellectual foundation for the grossly inflated pay packets many executives receive today.