Capital efficiency as an executive long-term incentive performance requirement

The most common executive long-term incentive (LTI) performance requirements for ASX listed companies are relative Total Shareholder Return (TSR) and Earnings Per Share (EPS) growth.

Far fewer companies have an explicit requirement for capital efficiency, such as Return on Capital Employed (ROCE), for an LTI to vest. Yet, in many respects, capital efficiency is a valid measure that should be reasonably aligned with value creation. It is the minimum return required to satisfy a company’s investors and creditors. Anything in excess of this return is added value.

A recent Citi Research report explored medium term Return on Invested Capital (ROIC) compared with a company’s Weighted Average Cost of Capital (WACC) as an indicator of company performance, and investigated how this “ROIC-WACC spread” aligns with executive remuneration. The expectation was that there should be a relationship, as positive returns above WACC add to shareholder value.

Citi Research looked at a five-year performance period and CEO pay over this period for 60 large companies. In addition to looking at the relationship between CEO and returns in excess of WACC, they also looked at the relationship between the capital return spread and TSR, and CEO pay and other factors.

They did find a relationship – that CEO pay varied with company size. Alas, Citi Research found no relationship between capital returns relative to WACC and CEO pay. In part this was attributed to the performance criteria on which CEO pay was contingent, such as EBIT, profit before tax, production, revenue, operating cash flow, earnings per share or total shareholder return. Performance against personal objectives also impacted CEO remuneration. Capital efficiency, it seems, was not an incentive metric of choice for most of these 60 companies. Moreover, Citi Research did not find a relationship between capital returns relative to WACC and TSR.

The Citi Research is nevertheless interesting, if only because it considers the variation in CEO remuneration relative to the value added in terms of capital efficiency.

We are not able to provide a link to the City Research paper, but interested subscribers can contact Citi Research directly and request a copy.

© Guerdon Associates 2023
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