Sir Martin’s problem with pay and performance

The debate between Sir Martin Sorrell and WPP investors is warming up nicely.  Yesterday, Sir Martin defended himself stoutly in an article written for the FT, much of which I found pretty persuasive.  He makes a good case for having created value across the patch – shareholders have seen above average returns over a long period, tens of thousands of employees have jobs and the result today, from a business formed in his front room, is the world’s largest advertising and public relations agency.  An extraordinary achievement indeed, and one that he would argue is worth every penny (and more) of what he is paid.

His little local difficulty, however, is that the 60% proposed rise in his pay packet this year compares with  WPP’s 10% under-performance against the FTSE during 2011.  And that of course is what has got shareholders angry.  If they didn’t get their return, why should he?

But this is exactly where the debate should be – working out how best to link management performance with shareholder returns.  There has been a considerable shift towards tying the two together over the past 20-odd years, but there are many who would argue that the right measures have not yet been chosen.  Too much emphasis on share price growth, for example, means that management may (or indeed, not take) actions which may threaten the price, for example making investments in the short term (such as marketing or R&D costs which will hurt profits) that will benefit the company in future years but only after they have departed and cashed in their options.

We think there are three core measures against which management performance should be judged and each falls neatly into the mantra we teach that says that growth plus returns creates value.  The measures are (a) EPS growth, (b) Return on Capital Employed or Capital Invested (ROCE or ROIC), and (c) Total Shareholder Return (TSR, the combination of returns to shareholders by way of dividends and share price growth in any one year).  There may be other KPIs that any individual company may choose to add (for example, in a company seeking to grow in emerging markets, the proportion of revenues derived from such markets), but any company that rewards its senior management team on a proportionate combination of these three metrics will find that rows with shareholders like that encountered by Sir Martin are few and far between.

CGI/Logica and shareholder value

It’s always interesting to take a close look at the press release announcing a deal.  People who have been on courses at FinanceTalking know full well about how we go on about the creation of shareholder value, by which we mean that the management of a company generate cash flows at rates of return that exceed the company’s cost of capital.  We add that growth matters too, because higher cash flows are obviously more valuable than lower ones.  And that’s it really.  That’s all that management has to do to create value.

We also teach that there’s too much emphasis on earnings per share.  It’s an easy metric to play with because on the face of it the company with higher earnings is making higher profits and then it’s easy to apply a multiple to earnings to get a sense of value – the price/earnings ratio.  But what EPS doesn’t tell you is how much capital needs to be invested to generate that growth and it can easily result in two companies with exactly the same revenue and profit profiles into the future being given the same value, even though one company’s cash flows are half of the other’s because of the greater need to re-invest.

So we always look for the bit in M&A releases that talk about the returns the acquisition will make on the capital being invested to purchase it and whether and when the acquisition will cover its cost of capital.  No mention of it in the CGI release yesterday on the acquisition of Logica.  Just the usual stuff about enhancing earnings per share (albeit by a very healthy amount, which suggests they’re buying it on the cheap).  The drafters of the release should check out the bible on Valuation written by McKinsey: “Deals that strengthen EPS and deals that dilute EPS are equally like to create or destroy value.”  Talk instead, McKinsey suggest, about the cash flow returns on capital and whether they are in excess of the cost of that capital.  That’s creating value, and that’s what will bring investors to invest in the story.