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What is CEO Talent Worth?

What is CEO Talent Worth?

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Published by Brian Tayan

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Published by: Brian Tayan on Jan 23, 2012
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Topic, Iue,  Cotoeie i Copote Goece  Leeip
stanord closer look series 1
Wt I CEO Tlet Wot?
Te topic o executive compensation elicits strong emotions among corporate stakeholders, practitio-ners, and observers. On the one hand are those whobelieve rmly that chie executive ocers in theUnited States are overpaid. Tey cite as evidencethe large and growing disparity between total pay granted to CEOs and the compensation o the av-erage worker.
Teir solution is the encouragemento more shareholder activism (primarily throughproxy measures, such as say on pay) to communi-cate concerns to companies and induce a voluntary reduction in compensation levels or stricter peror-mance-based eatures that more closely align com-pensation to nancial and operating results. Somego so ar as to suggest that CEO compensation beregulated at a xed multiple o the average worker’spay.On the other side o the issue are those who be-lieve that chie executives are paid the going air-market rate. Tey argue that i compensation levelsare high among the largest U.S. corporations, it issimply a reection o the demands o a positionthat require considerable time, skill, and attention.Tey advocate continued disclosure on compensa-tion size and structure so that market orces correctthe mispricing o talent in situations where it arises.Researchers have taken various approaches toevaluating whether CEO pay levels are appropriate.Gabaix and Landier (2008) measure the relationbetween CEO compensation and company size.Tey nd that although CEO pay increased six-old between 1980 and 2003, the market value o the companies these CEOs managed also increasedsixold during this period. Tey conclude that “therise in CEO compensation is a simple mirror o the
By dv . l, Um lq  B tyJuy 24, 2012
rise in the value o large U.S. companies since the1980s.”
Similarly, Kaplan and Rauh (2010) com-pare the growth rate o executive compensation tothe growth rate o other highly paid proessionals,such as hedge und managers, private equity man-agers, venture capitalists, lawyers and proessionalathletes. Tey nd that pay among these groups allgrew by roughly the same order o magnitude dur-ing the period 1994 to 2005. Tey conclude thatCEO compensation has increased due to marketorces that contribute to general wage inationamong highly paid proessionals, and that extremecompensation growth has not been limited to thebusiness world.
However, it is important to remember that dem-onstrating a correlation between executive compen-sation and rm size or perormance does not meanthat pay levels themselves are appropriate. It mightstill be the case that CEO pay itsel is either toohigh or too low on average.
Te only way to makea determination is to measure whether the totalcompensation received is commensurate with thevalue o services rendered. o do this, stakeholdersneed to understand 1) the value drivers o the or-ganization, 2) the impact that the executive has onthese value drivers, and 3) the percentage o valuecreated that should be appropriately ofered as com-pensation or perormance. While this is simple intheory, it is exceptionally dicult in practice.
Performance and comPensatIon
Te value drivers (or key perormance indicators)o an organization include the nancial and non-nancial metrics that reect the current and utureperormance o the company (see Exhibit 1). Tey might be generic in nature and applicable to most
stanord closer look series 2
What Is CEO talEnt WOrth?
companies (such as revenue growth, prot margin,and return on invested capital) or specic measuresthat are relevant to a particular industry or line o business (such as research and development pipe-line productivity or on-time delivery rates). Simi-larly, they might be readily quantiable (such asproduct deect rates) or more qualitative in natureand thereore require proprietary methods o mea-surement (such as customer and employee satisac-tion). It is the responsibility o management andthe board o directors to identiy the value driversthat are most critical to the success o the corporatestrategy. Tis process is best accomplished throughrigorous statistical testing that demonstrates a proven correlation between the relevant metric andchanges in corporate value.
Te valid perormanceindicators o the company then serve as the basis ormeasuring management perormance and awarding compensation.Te challenge or the board is to determine whatlevel o compensation to ofer to chie executive o-cers or the achievement o specic perormanceobjectives. Tis can be an extremely dicult task,not least o which because it is not always easy to de-termine how much corporate value creation shouldbe attributable to the eforts o a single individual.
  Although a considerable number o theorists andpractitioners have argued that CEOs play a criti-cal role afecting rm perormance, the empiricalresearch on this issue is mixed. Tomas (1988)nds that CEOs are responsible or only 3.9 per-cent o the variance in perormance among com-panies, while Mackey (2005) nds that the impactis much greater: as high as 29.2 percent.
Te view that board members have on this issue will have a substantial impact on what they view as reasonableCEO compensation (see Exhibit 2).Finally, the board must determine the percent-age o value creation to award in compensation. Although there are no agreed upon standards, ob-servation o compensation practices among othertalent pools might serve as a guide. For example,the CEOs that manage private-equity owned com-panies receive on average 5.4 percent o the equity upside (in the orm o stock and options).
A-listactors in Hollywood receive $10 to $30 million perlm, plus 10 to 20 percent o gross prots.
Musicartists receive 8 to 25 percent o the suggested re-tail price o an album, a $0.08 perormance royalty  when a song is played live or broadcast, plus a per-centage o the gross prot generated on tour (seeExhibit 3).
Similarly, in setting compensation orCEO talent, the board should target a payout inrelation to perormance or value creation. In thisregard, the structure o the compensation contract will be as important as its overall size.
Why thIs matters
1. Executive compensation is a topic that is lled with much rhetoric (“nobody is worth $20 mil-lion per year”) but somewhat less critical analysis(“maybe some CEOs are worth $20 million peryear while many others are not”). Why isn’t moreo the discussion ocused on the actual observ-able impact that a CEO has on value creationand the percentage o value that should be o-ered or these eforts?2. Why don’t we commonly see
calculationso actual value creation by the CEO in proxy statements? Is it not possible or boards to per-orm this calculation? I not, how does the boardmake rational decisions regarding pay levels?
Although precise gures vary depending on the sample and meth-odology employed, one recent estimate pegs this ratio at 343 among a sample companies in the S&P 500. See AFL-CIO Executive Pay- watch, available at:http://www.alcio.org/corporatewatch/pay- watch/.
Xavier Gabaix and Augustin Landier, “Why Has CEO Pay IncreasedSo Much?”
Quarterly Journal of Economics 
Steven N. Kaplan and Joshua Rauh, “Wall Street and Main Street: What Contributes to the Rise in the Highest Incomes?”
Review of  Financial Studies 
Further complicating the matter is the act that reported compensa-tion gures in the proxy do not reect what an executive has
but instead combine cash compensation received plus a air value es-timate o the expected value o equity compensation granted. I per-ormance does not meet expected results, the actual value o equity grants will be considerably lower than their original air value. For a ull discussion o this issue, see: David F. Larcker, Allan McCall, andBrian ayan, “What Does It Mean or an Executive to ‘Make’ $1Million?” CGRP-22, Dec. 14, 2011.
For a detailed review o this process, see: David F. Larcker and Brianayan,
Corporate Governance Matters: A Closer Look at Organiza-tional Choices and Teir Consequences 
, Chapter 6: OrganizationalStrategy, Business Models, and Risk Management (New York, NY:F Press, 2011); and Christopher D. Ittner and David F. Larcker,“Coming Up Short on Nonnancial Perormance Measurement,”
Harvard Business Review 
(Nov. 2003).
Sometimes it is even dicult to compute the value created by a rm.For example, does a one-year change in market capitalization validly reect the change in value creation over the period?
stanord closer look series 3
What Is CEO talEnt WOrth?
Alan Berkeley Tomas. Does Leadership Make a Diference in Or-ganizational Perormance?
 Administrative Science Quarterly 
(1988). Alison Mackey. How Much Do CEOs Inuence Firm Peror-mance—Really? (2005), available at SSRN:http://ssrn.com/ab-stract=816065.
Steven N. Kaplan and Per Strömberg. Leveraged Buyouts and Pri-vate Equity.
 Journal of Economic Perspectives 
Film Budgeting. Wikipedia.
Lee Ann Obringer, “How Music Royalties Work,” Available at:http://entertainment.howstuworks.com/music-royalties.htm.
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Corporate Gov-ernance Matters.
th uh wu   h M-h e. Gum  h   h pp h m.th s c l s     h u h xp p, u,  v p gv  hp. th c ls  pubh by h c  lhp dv-pm  rh  h s Gu sh Bu  h r c  cp Gv-  s Uvy.  m m, v:hp://www.gb..u/.cpygh © 2012 by h B  tu  h ls Ju Uvy. a gh v.

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