Conflicting incentives – MBA Learnings

In my last post about the tension between debt, shareholders, management and taxes, I ended with a line that leads straight into today’s post – “But, if there’s one thing I’ve learnt about markets, they’re rife with conflicts of interest.”

Let’s now take a look at the life of John Doe. John is an executive at a leading Fortune 500 company headquartered in the US. He gets paid $1 million in cash, 4 million in stock, and 20 million in various incentive related bonuses that are tied to “EPS” or earnings per share.

Now, let’s think about the many decisions he needs to make as a CEO that impact other constituents –
– How much debt should the company take on?
– How much tax will the company pay? (vs. how much of income will it recognize in low tax jurisdictions?)
– Should we pay dividends or repurchase shares?
– Should I take riskier investment bets or less risky bets?

Every one of these has an implication on the company’s profitability. And, a company’s profitability directly affects it share price. However, they do so in different place.

Let’s take dividends vs. share repurchases. When John’s company has a $100 in extra cash, they can either choose to pay the money in dividends to shareholders or choose to buy back their own shares from shareholders. Technically, they are both ways of returning money to shareholders. However, dividends inevitably reduce the share price (a company’s share price reflects the value of future cash flows – less cash available = less share price) while share repurchases generally have a positive effect on EPS.

While there are other impacts of making a dividends vs. repurchase decision, this difference alone highlights a conflict of incentives. John Doe and his executive team are often compensated on EPS. And, the markets often price stocks as a multiple of EPS. So, when the firm increases of EPS, it inevitable leads to an increase in share price. Now, it is great when that happens because of excellent management and/or smart investment bets. But, financial re-engineering, e.g. taking on excess debt, avoiding taxes, and/or repurchasing shares vs. paying dividends can also increase executive compensation significantly. John knows that he’s, at best, got a few good years as the CEO of this firm before he inevitably gets fired. So, why not make the most of it and swing these decisions in his favor?

There’s been a lot of discussion in the news about executive compensation as such decisions frequently come under scrutiny. In some ways, these conflicts make the markets fascinating. In other ways, they can make us cynical about decisions made by companies. My take has been to examine decisions more carefully to really understand what is going on and to understand the incentives in place. More often than not, the behavior we reward is the behavior we get.

One final plug on executive compensation – there are huge implications on the importance of ethics in these conversations. There has probably been an uptick in these conversations post the Enron debacle. I don’t think these conversations happen nearly as often as they should.

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