Stockholder wealth maximization is a long‐run goal or should be. Companies, and consequently the stockholders, prosper by management making decisions that will produce long‐term earnings increases. Actions that are continually shortsighted often “catch up” with a firm and, as a result, it may find itself unable to compete effectively against its competitors. There has been much criticism in recent years that U.S. firms are too short‐run profit‐oriented. A prime example is the U.S. auto industry, which has been accused of continuing to build large “gas guzzler” automobiles because they had higher profit margins rather than retooling for smaller, more fuel‐efficient models.
How do we make sure company stakeholders' interest are aligned - for example between stockholders and management? For example, useful and obvious tools that will help align stockholders’ and management’s interests include reasonable compensation packages, direct intervention by shareholders, including firing managers who don’t perform well, and the threat of takeover.
The compensation package should be sufficient to attract and retain able managers but not go beyond what is needed. Also, compensation packages should be structured so that managers are rewarded on the basis of the stock’s performance over the long run, not the stock’s price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so managers will have an incentive to keep the stock price high over time. Since intrinsic value is not observable, compensation must be based on the stock’s market price—but the price used should be an average over time rather than on a specific date.
Stockholders can intervene directly with managers. Today, the majority of stock is owned by institutional investors and these institutional money managers have the clout to exercise considerable influence over firms’ operations. First, they can talk with managers and make suggestions about how the business should be run. In effect, these institutional investors act as lobbyists for the body of stockholders. Second, any shareholder who has owned $2,000 of a company’s stock for one year can sponsor a proposal that must be voted on at the annual stockholders’ meeting, even if management opposes the proposal. Although shareholder sponsored proposals are non‐binding, the results of such votes are clearly heard by top management.
If a firm’s stock is undervalued, then corporate raiders will see it to be a bargain and will attempt to capture the firm in a hostile takeover. If the raid is successful, the target’s executives will almost certainly be fired. This situation gives managers a strong incentive to take actions to maximize their stock’s price.
Imagine you were a member of a Company X’s board of directors and chairperson of the company’s compensation committee. Now, what factors should your committee consider when setting the CEO’s compensation? Should the compensation consist of a dollar salary, stock options that depend on the firm’s performance, or a mix of the two? If “performance” is to be considered, how should it be measured? These questions should be carefully evaluated.The board of directors should set CEO compensation dependent on how well the firm performs. Obviously, the compensation package should be sufficient to attract and retain the CEO but not go beyond what is needed. Compensation should be structured so that the CEO is rewarded on the basis of the stock’s performance over the long run, not the stock’s price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so the CEO will have an incentive to keep the stock price high over time. If the intrinsic value could be
measured in an objective and verifiable manner, then performance pay could be based on changes in intrinsic value. Since intrinsic value is not observable, compensation must be based on the stock’s market price—but the price used should be an average over time rather than on a specific date. The board should probably set the CEO’s compensation as a mix between a fixed salary and stock options.
Now, what about division chiefs? how should they be compensated? Obviously, setting the compensation policy for a division manager would be different than setting the compensation policy for a CEO because performance of a division manager could be more easily observed. For a CEO an award based on stock price performance makes sense, while basing the compensation for division managers on stock price performance doesn’t make sense. Each of the managers could still be given stock awards; however, rather than the award being based on stock price it could be determined from some observable measure like increased gas output, oil output, etc.
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