Arizona State University professor Luis Gomez-Mejia recently went looking for a correlation between executive compensation and stock performance in an analysis of more than 300 published studies on pay and corporate performance. His conclusion: There isn't one.

Given the dreary performance of the stock market and the stream of stories highlighting executive pay run amok, investors might even think stock returns and executive pay are negatively correlated. Consider: The S&P 500 fell 23.4% in 2002, yet the average CEO earned $10.8 million in pay, bonuses and options, according to the AFL-CIO.

Of course, much of corporate America, Wall Street, the media and individual investors still tie the two together. Compensation committees heaped massive stock-option grants on executives during the past decade -- a practice that smacks of rigor but facilitated more unproductive greed than any other bull-market custom.

What's more, many CEOs took credit for their stock's heady gains during the one-way bull market of the 1990s, and many investors assigned sole blame to the same CEOs for the one-way bear market of the past three years. It is unlikely so many CEOs lost their touch at the same time. Many factors that went into, say, Qualcomm's ( QCOM) 2,619% rise in 1999 or its 27.9% fall in 2002 were forces beyond the control of Chief Executive Irwin Jacobs (of course, the rich stock-option package he received does fall largely within his control, but that's another matter).

We here at TheStreet.com are all about fairness toward the executives of corporate America. This proxy statement season, amid reports of eight-figure pay packages for executives whose stocks spent the year in freefall, we sought to use a more appropriate measure against which to compare CEO pay. For guidance, we turned to Warren Buffett, as many investors do these days. "The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.)," wrote Buffett in a 1983 letter to shareholders.

With that in mind, we introduce ROE v. Paid, a weeklong series comparing how executives stack up in terms of compensation and return on equity. Return on equity, or ROE, derived by dividing common stock equity into net income before dividends, is one of the easiest and best ways for investors to determine how effectively their money is being employed. Over the next week, we will list every company in the S&P 500, ranking them by their average five-year return on equity (we also include one-year ROE) and including the most recently reported compensation level for its CEO, as compiled by the data-crunchers at eComponline.com . Since it's a rather long list, we've broken up the stories and ROE v. Paid charts into the 10 industry categories as defined by the S&P 500. Oh, and for the stock-market scorekeepers out there, we also included every company's stock performance during the year.

So, how did our leaders of industry stack up against ROE? In a word, mixed. Of the S&P 500 companies, 208 had five-year ROE above 15%. "If companies can't deliver above 15% return on equity over rolling three-year periods, those generally aren't the stories that interest us," Century Small-Cap Select Lanny Thorndike said in a recent interview. On the flip side, 38 S&P 500 companies had negative average five-year ROE, including 20 in the technology sector. (Want to see how chiefs at Dell, Yahoo!, Nextel and others stack up? Click here to see today's feature on the information-technology sector and here to see today's companion piece on the telecommunications services sector.)

Is CEO Pay Fair?

The gulf between performance, as measured by ROE, and compensation does raise thorny questions at a time when CEO salaries have reached extremely high levels. In 1980, the average CEO made 42 times what the lowest worker earned. In 2001, the multiplier was 411. S&P 500 CEOs made more than $6.4 billion in compensation in 2002. Is it right to pay CEOs so much?

"I think right or wrong is a pointless discussion -- it's what the market will bear," said Catherine Daily, a professor at Indiana University's Kelley School of Business who has conducted a number of studies on compensation and performance and, like Gomez-Mejia, finds little or no correlation. "When you look at the outliers like Tyco ( TYC) and WorldCom, it is outrageous, but we're damning a system for a few notable cases."

Daily said that most CEOs aren't excessively compensated, it's merely the extreme cases that draw the media's attention. What's more, she says, many executives deserve to be well-paid. Roberto Goizueta received $1.33 billion in compensation during his 16-year tenure as chief executive of Coca-Cola ( KO). During that time, Coca-Cola went from $4.3 billion in market capitalization to $152 billion -- meaning his compensation represented 0.9% of the increase in market cap. "It's hard to be angry about that, given the return he gave to shareholders," Daily said.

A more recent example might be Reuben Mark, the chief executive of Colgate-Palmolive ( CP), who wins accolades from the media he so assiduously tries to avoid. Mark's annual compensation runs in the eight-figure territory, but his company's five-year ROE comes in at 160.1%, the second-best tally of the 500 companies on the ROE v. Paid list.

Others say there's no "efficient market" when it comes to executive pay. "We've just gone through the worst bear market since the Great Depression, yet executive compensation levels are still on the same magnitude as they were in 1999, at the height of market frenzy," said Brandon Rees, a research analyst at the AFL-CIO. Rees noted that executive compensation isn't set by the marketplace; it's typically by a board of directors.

"The CEO market is not really a free market," said Charles Peck, a compensation expert at The Conference Board. "The package is determined by the compensation committee of the board. The board generally works for the CEO."

Peck said a big problem stems from using stock performance to gauge executive performance -- and, hence, compensation. "The question is, is the measure of performance used the proper one?" Peck asked. "For a few years in the past, performance was measured by company stock. The general agreement was that increased stock was a benefit of shareholders. That caused the heavy utilization of options."

Options and the Law of Unintended Consequences

The primary culprit in runaway compensation is the supposed "solution" to the pay dilemma formulated more than a decade earlier: stock options.

"The same people who said options were the answer to excessive compensation are the ones now saying options-based compensation is a bad thing," Daily said.

According to Daily, the average CEO salary from 1996 through 2001 was $880,000 a year. It's the lucrative options grants and bonuses that push compensation into the stratosphere. The idea behind doling out options is sound: Have an executive's performance pegged to shareholder returns.

However, the institutions got it only half-right, according to Bruce Ellig, author of The Complete Guide to Executive Compensation . "It's not simply that CEOs should be paid for creating shareholder value, they should be paid for sustaining shareholder value," Ellig said.

"Excessive stock options can serve as incentive to take overly risky business strategies or, in worse cases, fudge the numbers," said the AFL-CIO's Rees. "With Enron, Tyco and the other scandals, they were preceded by excessive options compensation."

Investors may take cold comfort in the fact that the very excess that options grants helped spawn might mean such freewheeling compensation is a thing of the past. Many stock options are now under water, meaning the exercise price is below the value of the stock, making them worthless. Of course, CEOs have a few ways around that.

One primary way to get around underwater options: repricing. Many executives, as part of a retention policy, have had worthless options repriced so that they are again valuable. "There is no justification for this -- shareholders don't benefit from this do-over mentality, and they certainly don't get do-overs," Daily said.

Daily counts a certain computer company as high on the list of repricing offenders: "Apple is a serial repricer." By the way, Apple founder Steve Jobs tops the executive compensation list for 2002. His take: $89,887,282. For what it's worth, his company's five-year average ROE is 15% even. Apple's ROE for 2002 is a 1.62%. The stock was off 34.6% for the year.

The Conference Board's Peck and others anticipate reforms will take hold, especially in the form of options-based compensation.

"What I anticipate is more judicious use of stock options," Peck said. "What I think you'll see is a trend away from heavy utilization of stock options and a turn to what they call full-value stock -- moving to restricted stock that they have to earn by performance over a three- to five-year period."

Companies may also base compensation on a variety of measures beyond stock performance, including profitability, long-term growth and, yes, return on equity.

In the meantime, investors would be well-served to pay closer attention not only to executive compensation, but also valuation measures such as return on equity.

"With return on equity, basically, you're looking for companies who can earn in excess of their cost of capital," said Rich Eisinger, co-manager of the Mosaic Mid-Cap fund. "If you can fill a portfolio with those guys, you're going to have a winning return."

Of course, our ROE v. Paid list isn't without its anomalies. If a company, because of quirks in its reported earnings, has one blowout year on ROE, it inflates its five-year average. ( Dow Jones ( DJ), for instance, had ROE of 557% in 2002, which skews its results -- many investors in the long-suffering stock might take exception with CEO Peter Kann's high ROE ranking.) Nonetheless, in general, the five-year ROE is a solid barometer for gauging how a company uses its shareholders' money.

Which brings us back to Buffett. Eisinger cited something Warren Buffett said at his conference over the weekend: Look for companies where the management is in love with the business and not the money. Eisinger cites one stock, too small for the S&P 500, that fits this bill: Fastenal ( FAST), a Winona, Minn.-based industrial goods company run by Bob Kierlin. Kierlin pays himself about $100,000 a year, and any stock options the company grants come out of his personal holdings. "You won't find that often," Eisinger said.

Fastenal, by the way, has a five-year average return on equity of 22.6%. Maybe Buffett and followers like Eisinger are onto something.

Stay tuned for sector-by-sector rankings of corporate chieftains by return on equity over the next week. We'll conclude the series with a look at the Best and Worst CEOs according to ROE v. Paid.