A Practical Tool


Performance Sensitivity AnalysisSM (PSA) is a proprietary statistical method that identifies and measures the different sources of volatility in a company’s total shareholder return.[6] It can identify the portions of month-to-month volatility in shareholder return that are attributable to industry-driven, market-based, and firm-specific factors. (Sometimes one can measure volatility on a weekly or quarterly basis as well, depending on the circumstances.) With PSA output in hand, decision makers can better differentiate the true performance of a firm’s human capital from the external factors that move its share price around. That makes it possible to establish clear, cost-effective incentives that lessen the exposure of employees to systematic risk.

How It Works

PSA measures the correlation of a company’s shareholder return with indexes of both industry and general market performance over a designated period (usually three to five years). More specifically, it statistically decomposes the overall volatility of shareholder return into three components:

  • General market volatility as measured by an index of stock market performance (e.g., Standard & Poor’s 500, Datastream World Equity)

  • Industry volatility as measured by an index of peer group performance

  • Company-specific volatility: the part that is not statistically explained by industry and market movements

The third component is a “residual,” the part of volatility that is not explained by movements in the two performance indexes. The analysis produces both market and customized industry “betas,” which indicate the sensitivity of a company’s performance to these external influences.

Two requirements must be met to decompose stock price volatility into its three component parts effectively. First, a peer group must be created to represent the industry or market segment or segments in which the company operates. Second, the likely correlation of industry and market movements must be accounted for; that is, the movements in industry performance that are driven by movements in the overall market must be filtered out of the industry index to avoid confounding the measures. Once two truly independent performance indexes are created, it is possible to statistically model the way changes in those indexes drive changes in a company’s shareholder return.

The uniqueness and practical value of PSA stem from the methodology used to measure industry performance. Since industry-specific risk is in fact the great dividing line between investors and employees, imposing different costs on those stakeholders, the measure used to capture movements in industry performance is critically important.

The goal is to maximize the ability to draw statistical inferences about the effects of environmental factors on the performance of firms in the same sector. The degree of comovement between stock prices is a measure of the extent to which companies are affected by common environmental factors, both market-driven and industry-driven. Since the stock prices of firms exposed to the same environmental factors tend to move more in tandem than do others, more weight is assigned in the industry performance index to firms whose stock prices move more closely with that of the company of interest.[7]

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PSA in Three Steps
  1. Identify the appropriate industry sector. This is more difficult than it appears to be. What constitutes the industry, all industry segments in which the company operates significantly or only the industry segment from which it generates the highest percentage of revenues? This is a tough question for highly diversified companies.

  2. Construct a “filtered” industry return index. This index is composed of peer group companies, with overall group performance weighted by the degree of comovement in stock prices. Statistical methods then are used to remove the effects of general movements in the stock market on the index.

  3. Use the industry and general market indexes to estimate the impact of general market and industry movements on the firm’s shareholder return statistically.

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Applying PSA

Figure 10-3 describes how PSA methodology was used in one case to decompose total shareholder return (TRS) volatility (as measured by the variance of monthly TSR in the three-year period 1999–2001) into market, industry, and firm-specific factors. The companies involved were in the FTSE100 media and photography sector. It is clear that aside from differences in the overall volatility of those companies, the breakdown of risk varied dramatically as well. For instance, Reuters and WPP shares were found to be extremely sensitive to combined market and industry dynamics, whereas those of Reed International and EMI Group had the highest levels of firm-specific volatility. Like WPP, Granada has high volatility that is driven substantially by market dynamics, whereas Sky appears to be virtually immune to the influence of market movements. To draw conclusions about the risk profile of any one of these companies solely on the basis of knowledge of their sector clearly would be misleading.

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Figure 10-3: Volatility Decomposition in FTSE 100 Media & Photography Companies

The observed differences in the risk characteristics of these companies bear directly on the impact and cost of transferring risk from investors to employees through the use of stock-based rewards. The market risks shown in the figure cannot be reduced by either investors or employees. However, industry risk, like firm-specific risk, can be reduced or eliminated by investors through diversification: Those investors can adjust their portfolios to achieve the risk-return relationship they desire. However, as we have noted, employees cannot diversify the human capital investments they make in their companies. Industry risk thus imposes a differential cost on them that ultimately must be compensated, often in the form of larger stock grants or other variable pay opportunities.

Returning to Figure 10-3, one can see that Sky and Reuters exhibit high levels of industry risk, which may mitigate against heavy reliance on stock-based rewards. Those companies need a mechanism for filtering out the effects of industry risk on their employees’ rewards. In contrast, companies with high levels of firm-specific variation, such as Reed, may be able to use stock or stock options to deliver stronger incentives to their employees at a lower cost to shareholders than can others in the industry. Employees would see a stronger link between the rewards they received and what they actually did.

How to Use PSA Solutions

The examples given above underscore the practical value of PSA as a guide for dealing with risk in decisions about human capital policy and apportioning risk between shareholders and employees, especially through the vehicle of variable pay. At the very least, knowing the risk profile of a company’s total shareholder return can help that company determine whether stock-based pay and other forms of incentive compensation are likely to be cost-effective as employee performance incentives. High levels of systematic risk, particularly fluctuations emanating from industry movements, raise a red flag about the likely effectiveness of such rewards. In these instances stock and even stock options are likely to prove costly to shareholders—say through dilution—even as they fail to deliver strong and consistent incentives for employees.

Does this mean that a company should forgo stock-based incentives completely? In some instances this may be the best solution. But of course stock-based pay has purposes beyond incentive considerations. It can be used to create a culture of cooperation, ownership, and responsibility for business outcomes. It is hard to imagine a true “ownership culture” without employees having a direct stake in shareholder value. Thus, finding ways to mitigate the adverse consequences of misallocated risk would be beneficial to all.

PSA provides a method to accomplish this goal. By measuring the components of risk, it provides a basis for developing risk-adjusted measures of performance, measures that to some degree filter out the effects of random environmental factors. Companies then can determine precisely how much systematic risk they want their employees to bear. They also can strengthen performance incentives by tying rewards more closely to the unsystematic component of performance. In this way, the “line of sight” becomes clearer.

This is not the place to undertake an exhaustive review of alternative ways to create risk adjusted performance measures, but let’s be clear about the essential principle: Performance should be assessed relative to the risks that accompany it. One of the simplest ways to accomplish this is by measuring relative performance. This means basing incentive pay on a comparison to the company’s performance relative to a weighted average of the same measure for peer group companies. Hence, if the focus is on total shareholder return, the company’s TSR should be compared with the weighted average TSR for peer companies or for the market as a whole, depending on which measures most influence company performance. Financial gains should be realized if management demonstrates through this means that it is outperforming competitors or exceeding investors’ expectations. Since competitors in the sector face similar environmental conditions, the use of relative performance filters out those influences and provides a better read on how the company’s management and employees actually have performed.

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Myth Buster: Pay for Results? Not Always

It seems that every company these days exhorts employees to be “results-oriented,” and why not? Shareholders are concerned with outcomes, not effort or intentions. Why should they reward anything but successful outcomes? For good reason, it turns out. Sometimes rewarding results makes it more difficult to achieve good results.

Take the case of stock. Since the primary duty of management is to increase the market value of their companies, it would seem sensible to link rewards directly to changes in shareholder value: the ultimate “result.” But whose performance is being rewarded when rewards are linked to stock price? Although share price appreciation is the ultimate measure of firm performance, it is a very imperfect indicator of management or employee performance, especially in companies whose share prices are highly volatile and are driven by market and industry fluctuations. In those companies the presence of external factors over which executives and employees have no control transforms stock-based incentives into a kind of lottery in which bull markets generate large rewards and bearish ones wipe out gains.

What does running a lottery have to do with delivering performance incentives? Distinctions between competence and luck, between the results of business acumen and the effects of random market and industry factors, are blurred. As a consequence, those rewards end up providing little in the way of motivation even as they increase compensation costs. They also can lead to defections among valued personnel who find that their stocks or stock options are worthless even though they have performed well beyond market expectations. This is a sure way to undermine commitment and make those employees prime targets for recruiters representing rival firms who are cherry-picking talent in a down market. Net result: Company performance is hurt, not helped.

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For stock options, the use of relative performance could mean formally indexing the exercise or strike price of an option to changes in peer group and/or market performance. Alternatively, the company could adjust the size of grants offered to employees on the basis of how well the company performed compared with an established peer group. In this way executives and other employees in companies that outperform the peer group are given larger grants in the following year. There would be no rewards for performance that increased simply because of systematic market and industry forces. Instead, employees would share only in value associated with firm-specific performance, value they have created through their diligence and effort.

These are just a few potential solutions for improving the effectiveness of incentive compensation systems. They add some complexity to incentive design, but that is far less onerous than the problems that often arise with more traditional pay for performance plans. Companies that fail to allocate risk efficiently through their incentive programs invariably end up with higher compensation costs (including dilution), higher turnover, skewed decision making, or a combination of all three.[8] The quality of decision making becomes compromised as executives are influenced more by their personal tolerances of risk than by a prudent evaluation of prospective shareholder returns. This could be the most costly outcome of all.

[6]An early version of PSA was introduced in Nalbantian (1993). The article provides more detail on the methodology and its applications.

[7]This approach to weighting industry peers is inspired by R. Antle and A. Smith, “An Empirical Investigation of the Relative Performance Evaluation of Corporate Executives,” Journal of Accounting Research 24: 1–39.

[8]There is evidence that executives heavily discount the value of stock options due to the risks they face. B. Hall and K.J. Murphy (“Stock Options for Undiversified Executives,” NBER Working Paper No. W8052, November 2000) estimated that the value of stock options is granted at the money ranges from 21 percent to 64 percent of their Black-Scholes value, depending on executives’ risk preferences and the diversification of their wealth. With such discounting, pressures to increase the size of grants is high. The cost to shareholders shows up in dilution of shares—a significant problem for many companies today.




Play to Your Strengths(c) Managing Your Internal Labor Markets for Lasting Compe[.  .. ]ntage
Play to Your Strengths(c) Managing Your Internal Labor Markets for Lasting Compe[. .. ]ntage
ISBN: N/A
EAN: N/A
Year: 2003
Pages: 134

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