The Art and Science of Measuring CEO Performance

According to Northwestern's Cadman, there can be disadvantages in using softer metrics, such as customer satisfaction or success in research and development projects. Success in customer service may improve revenue and earnings in the future, but it may be difficult to assess whether it is boosting revenue and earnings in the current quarter or over the next year.

A growing number of companies are using performance measures as long-term incentives for chief executives. According to the Mercer Human Resource Consulting 2006 CEO Compensation Survey, the number of CEOs receiving shares of stock based on performance, including performance-contingent restricted stock, rose from 111 in 2005 to 178 in 2006. The survey, which included 350 large public companies, was released in April 2007.

The New "Discussion" Section

As a result of new government regulations, stockholders now have more information available to them than ever about how a firm measures CEO performance and how those measures are used to determine compensation. Instead of just reporting the compensation of their top five executives, companies now must include a "discussion" section that explains how compensation is determined. The new disclosure requirements took effect with annual proxy statements filed with the Securities and Exchange Commission after December 2006. Those statements began showing up in the mailboxes of shareholders in the spring 2007 reporting season.

"Things used to be nebulous," says Wharton's Carter. "Now, shareholders are getting much more detailed information as to how boards structure executive pay."

Elson agrees that the new SEC disclosure requirement is a good thing. "The more information that the marketplace has about how compensation is formulated, the more informed shareholders are and the better decisions they can make to elect or not elect a director," he notes. "I'm a fan of greater disclosure. It [the corporate proxy] is much fuller, particularly on things such as perks, which were not as clear before."

For example, in its most recent proxy statement, Bank of America's (BAC Quote) compensation committee sets forth -- in an easy-to-read table -- five "performance measures" and the "reasons" that the committee uses those measures. The measures are: revenue, net income, operating earnings per share, shareholder value added and total stockholder return. "Our financial success begins with our ability to grow revenue," the proxy explains, but it also emphasizes that revenue growth is not sufficient "unless it leads to growth in our net income."

In explaining operating earnings per share, the proxy states that the compensation committee looks "to this measure to make sure that our net income growth is being achieved over time in a manner that is accretive for our stockholders." It goes on to say that the inclusion of shareholder added value as a metric "places specific focus on whether the investments we make in our businesses generate returns in excess of the costs of capital associated with those investments." The proxy also states that Bank of America uses the metric of total stockholder return -- which takes into account both stock-price performance and dividends -- "as the ultimate means to compare our performance for our stockholders relative to our competitors."