In the battle over executive pay, most of us would agree that linking it to return on equity – as many companies do – is a dodgy idea. Instead, some would prefer to use return on capital overall. It is an appealing thought, but problematic.
The trouble with return on equity, as the banks have starkly reminded us, is that it encourages boards to take undue risks. Return on capital, by contrast, has the virtue of measuring the use made of all the company’s financial resources.
But while the metric is clear, interpreting it is another matter. For instance, we might expect capital-intensive industries such as mining to have lower returns than service industries. Not necessarily.
The Mexican silver and gold miner Fresnillo had a ROC last year of 60 per cent (measured as pre-tax profits to total assets less current liabilities). Its fellow-FTSE 100 member WPP, the advertising giant, had a return of 8 per cent.
One reason is obvious. The price of silver and gold has rocketed, so Fresnillo’s pre-tax margins last year were 70 per cent compared with WPP’s 10 per cent.
Less obvious is the fact that WPP, which was largely built through acquisition, has goodwill and intangibles on its balance sheet equal to 88 per cent of capital employed. If we did not know that – if we went simply by the ROC number – we would impute failure to what is in fact a flourishing company.
Very well, you might say. ROC is not a good basis of comparison between sectors. So let us look at three ostensibly similar companies: the internet trio of Microsoft, Google and Amazon.
Last year, their ROC was 35 per cent, 19 per cent and 9 per cent respectively. We might expect the rating of their stock to reflect the fact. And so it does – but in reverse order. Microsoft’s multiple of historic earnings is 11, Google’s 17 and Amazon’s an astronomic 139.
There are various reasons for that, but they mostly relate to each company’s stage of development. Microsoft is the most mature, as reflected in total revenue growth of only 20 per cent over the past two years.
Amazon, at the opposite end of the spectrum, had almost 90 per cent growth, with Google in between. Conversely, Microsoft had 40 per cent margins compared with Amazon’s 2 per cent.
That does much to explain the difference in returns. What about the capital part of the equation?
The most obvious difference lies in each company’s pile of cash or near-cash, which these days produces negligible returns. The mature Microsoft has less need of a cushion, so its cash pile accounts for only 66 per cent of its capital employed. Amazon’s accounts for 92 per cent, with Google again somewhere in between.
Once more, then, the raw ROC numbers are misleading without further analysis. Indeed, it is not clear what they tell us beyond the analysis itself.
But supporters of ROC go a step further. The figure must be compared with the cost of capital. For, as a senior fund manager recently put it to my colleague Steve Johnson, "should returns not be above the cost of capital, the company cannot sustain itself over the longer term”.
Fair enough, you might think. The trouble is that the cost of capital, though a clear enough concept, is in practical terms a chimera.
The snag lies in the cost of equity. Old-style financial theory says this has three components: the risk-free rate, the equity risk premium and the beta of the individual stock. Each is suspect.
What is the risk-free rate? We know the present yield on US Treasuries of 2 per cent, for instance, is rigged by government. So let us project the historic 10-year average of 3.8 per cent instead.
But if we had done the same a decade ago, the historic average would have been 6.1 per cent, or 230 basis points away from the outcome. Two decades ago it would have been a further 340 basis points out. These are not rounding errors. They reduce the whole exercise to gibberish.
The equity risk premium, in turn, is subject to a similar backward-looking fallacy. We know what it was, but not what it is today.
As for beta, it is taken to be a measure of the risk attached to the company. In fact, it merely reflects the volatility of investors’ expectations. Financial theory says the two are the same. They are nothing of the kind.
All in all, while investors are right to object to the performance measures in use today, finding new ones is harder than it looks.
Copyright The Financial Times Limited 2012.
Mind the executive pay gap
There are plenty of reasons to balk at the idea of linking executive pay to return on equity. But finding a better performance measure is harder than it seems.
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