Figuring out how much a CEO really makes in any given year is a tricky task. It's not like the old days when pay consisted of a check in an envelope that you got every Friday afternoon. These days, the number for CEOs depends largely on how you value stock options, the most essential part of their compensation.
This year's poster child for executive-pay reform, Oracle Corp. (ORCL ) founder Lawrence J. Ellison, either made the most ($706 million) or lost the most (a staggering $2 billion) last year. Which of these two numbers is more accurate and reasonable? It's an important question, because the answer could well alter the stormy debate over executive pay.
For years, BusinessWeek has reported all the gains from a stock-option exercise in a CEO's annual compensation. The reason: That income is taxable and reported to the Internal Revenue Service. Others, however, place a hypothetical value on a new stock-option grant in the year it is given. Even worse, some observers now do both, double-counting the same goodies so that the numbers look much larger than they actually are.
Sure, it's hard to work up any pity for someone making tens or hundreds of millions of dollars a year. But it's unfair and misleading to dump theoretical grant values or option gains in a single year's pay. Option gains are earned over a period as long as 10 years, while grant values are meant to predict an option's worth over its entire 10-year term.
As option income overwhelmed cash pay, this problem made it difficult to match pay to shareholder returns in a single year. "There are plenty of abuses going on in executive compensation, but saying there is no link between a CEO's total pay and performance is a wrong conclusion," says Fred Cook, founder of Frederic W. Cook & Co., a prominent pay consultant. "It's the measurement that's wrong."
For the first time, BusinessWeek is adding a new measurement called "pay-related wealth" to account for option gains and losses. It measures the change in value of all vested, unvested, and exercised stock options over the reported year. Added to this number is the executive's base salary, bonus, and the value of any restricted stock grants.
What the new methodology clearly demonstrates is that a CEO's financial health is directly related to his company's performance. When shareholders suffer, the CEOs almost always lose a big chunk. Last year, with the stock market in a tumble, the average CEO lost $15.4 million in pay-related wealth. Some 28 out of 365 CEOs in the BusinessWeek study, ranging from Merck & Co.'s (MRK ) Raymond V. Gilmartin to Colgate-Palmolive Co.'s (CL ) Reuben Mark, lost more than $50 million each.
Of course, the only way a CEO can lose that much is to have a ton of options to begin with. Consider Cisco Systems Inc. (CSCO ) CEO John T. Chambers. With shareholder return down 72% in fiscal 2001, Chambers lost $931.4 million in pay-related wealth, a drop of 85%. The $268,131 in cash he received could hardly offset the more than $950 million hit to his stock options. Even so, his in-the-money options were still worth $194.4 million at the end of the fiscal year.
Walt Disney Co.'s (DIS ) Michael D. Eisner, a perennial money-maker in the CEO pay sweepstakes, lost nearly 100% of his pay-related wealth in the past fiscal year as shareholder return fell 51%. How can any executive lose almost all of his pay-related wealth? After drawing down a $1 million salary for the year, Eisner found that all his 21.4 million options were under water. But bear in mind that he already has taken home more than $1 billion in salary, bonus, and option exercises since becoming CEO of Disney in 1984.
The biggest winner on the pay-related wealth measure was Henry R. Silverman, CEO of Cendant Corp. (CD ) His pay-related wealth jumped 64%, to $250.9 million. Shareholders aren't complaining, though: They saw returns of 104% on their investment in Cendant in the same period. IBM's (IBM ) Louis V. Gerstner Jr. was right up there with Silverman. Gerstner's sum rose by 49% last year, to $240.5 million, as shareholders saw their returns increase 43%.
Our new measure has an added advantage: Many retiring CEOs wait to exercise their options until they no longer appear in the proxy statement. So they walk off with tens of millions of dollars of pay that never gets accounted for. This new methodology captures those gains throughout the CEO's tenure.
It also shows the dramatic leverage stock options give CEOs, particularly on the way up. When shares swing upward, CEOs reap vast rewards that often far outdistance those of investors. In a year when Tenet Healthcare Corp. (THC ) shareholders enjoyed returns of 78%, CEO Jeffrey C. Barbakow's pay-related wealth shot up by 204%, to $96.9 million. At Electronic Data Systems Corp. (EDS ), investors had returns of 20%, but CEO Richard H. Brown had a 226% increase, to $52.7 million. But when stock prices decline, the CEOs' fortunes tend to fall in line with those of shareholders, at least in percentage terms. Even Ellison's 58% decline in pay-related wealth was virtually equal to the 57% fall in shareholder return.
Why the big boost on the way up? It's largely in the math. If a stock climbs to $50 a share from $40, the shareholder return is 25%. But if a CEO's option is priced at $39, and the stock starts the year at $40 and ends the year at $50, his pay-related wealth increases by 1,000%. An analysis by consultants Michael P. Chavira and Beverly W. Aisenbrey with Cook & Co. found that options are typically leveraged at a multiple ranging from one to five times total shareholder return. It's another reason why boards need to be more stingy when they hand out grants.
By John A. Byrne in New York