STANFORD CLOSER LOOK SERIES
Topics, Issues, and Controversies in Corporate Governance and Leadership
Sensitivity of CEO Wealth to Stock
Price: A New Tool for Assessing Pay for
Performance
By David F. Larcker and Brian Tayan
September 15, 2010
Pay for Performance
In recent years, much attention has been paid to
the suitability of CEO compensation among U.S.
firms. Of particular concern are whether total compensation packages are too large, whether they encourage “excessive” risk taking, and whether they
are merited given the performance of the company.
This last issue is known as “pay for performance”
and gets at the question of how closely compensation is correlated with the results the executive
generates.
There is considerable debate as to whether pay
is actually correlated with performance in U.S.
companies, with evidence to support both sides.
On the one hand, many elements of the compensation package are explicitly linked to performance
targets. For example, the annual bonus is awarded
based on an executive’s ability to achieve objectives
that are established at the beginning of the year.1
The size of the bonus directly scales in proportion
to the executive’s success in these areas. Also, CEOs
receive a significant portion of their compensation
in the form of equity awards (stock options and restricted stock). The value of this compensation is
directly tied to share price and, in the case of stock
options, has zero value if the stock price is below
what it was on the grant date. The structure of these
payments indicates that there must be at least some
pay for performance.2
On the other hand, there have been a considerable number of large payments made to executives
whose companies have not performed particularly
well. For example, in 2007, Robert Nardelli (CEO
of the Home Depot) received a severance package
of $210 million, even though he resigned under
pressure from shareholders who were frustrated
with the company’s performance during his six-year
tenure.3 Richard Fuld (CEO of Lehman Brothers)
sold stock awards worth almost $200 million and
Angelo Mozilo (CEO of Countrywide) almost
$500 million, none of which they were required to
repay through “clawbacks” when their companies
collapsed in the financial crisis of 2008.4
Measuring Pay for Performance
In discussing pay for performance, the business media often highlights payments made to an executive
in a given year. This measurement, however, is misleading for two reasons: 1) it involves compensation payouts that accrued over a number of years,
and 2) it is not framed in terms of the shareholder
value created during the executive’s tenure.5
For this reason, it is more instructive to examine
the relation between CEO “wealth” (measured in
terms of equity ownership through stock and options) and stock price returns. One way to make
this assessment (and a method favored by academics) is to measure the dollar change in CEO wealth
over small percentage changes in the stock price.
Based on a sample of 4,000 publicly traded U.S.
companies, the average (median) CEO stands to
gain roughly $58,000 in wealth for every 1 percent
increase in stock price. Among the largest 100 companies, this figure approaches $640,000.6
A potentially more informative method is to
consider the change in executive wealth over larger
changes in stock price (after all the CEO is hired
to do more than increase the stock price by 1 percent). An easy way to do so is to plot the percentage
change in the expected value of the CEO’s equity
portfolio against percentage changes in stock price
ranging from -100 percent to 100 percent. The 0
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Sensitivity of CEO Wealth to Stock Price: A New Tool for Assessing Pay for Performance
percentage point on the x-axis is based on CEO
wealth at prevailing market prices and the -100
percentage point is where the value of equity goes
to zero. By graphing this data and comparing these
results to direct competitors or peer firms, observers
can better understand the relative risk and reward
being offered. Of particular note is the “convexity”
of the payout curve. For example, a manager who
is rewarded predominantly in restricted stock or
only holds stock will see a change in wealth that
is essentially linear (low convexity) and coincides
one-for-one with the change in wealth of the average shareholder. By contrast, a manager who is rewarded predominantly in stock options (especially
those with tranches of stock options with different
exercise prices) will see a change in wealth that has
a much steeper payout curve (high convexity) and
promises significant wealth for superior performance.7 Payout curves with high convexity may encourage more risk taking, while payout curves with
low convexity may encourage less risk taking. This
can be good or bad, depending on the strategy of
the organization.8
As an example, we can consider the relation between pay and potential performance for a series of
direct competitors:
• Regulated utilities: If the stock price of Southern Company increases by 100 percent, the
CEO of the company’s Georgia Power division
will realize a 235 percent increase in “wealth” (a
ratio of 2.35). By comparison, the ratio at Exelon’s ComEd division is 1.23. Compensation at
Southern Company therefore seems to encourage more risk taking. Under what circumstances
is it appropriate for a public utility to engage in
risky activities (see Exhibit 2)?
• Food companies: The CEO of General Mills has
convexity in his compensation of 2.98, while the
CEO of Kraft has convexity of 1.18. The CEO
of General Mills, however, was appointed to the
position during the year. While it can be appropriate to use options to help a CEO build wealth
in the company at a faster rate, will a more aggressive compensation structure impact company strategy and risk (see Exhibit 3)?
• Pharmaceutical companies: The CEOs of Johnson & Johnson and Abbott Laboratories have
higher convexity in their compensation (2.26
and 2.13, respectively) than the CEOs of Pfizer
and Merck (1.78 and 1.67). Does a diversified
healthcare model require more risk taking than a
pure-play pharmaceutical model (see Exhibit 4)?
While it is difficult for outside observers to determine whether these payout functions are appropriate, this is the type of analysis that the compensation committee can review to make a reasoned
assessment of whether compensation contracts are
providing appropriate incentives for performance,
and gauge their potential to encourage “excessive”
risk taking.9 These are also key inputs for analysts
attempting to make a judgment about future cash
flows and risks associated with a company.
Why This Matters
1.The current debate on pay for performance is
characterized by heated rhetoric with little concrete analysis to inform conclusions. Measuring
the relation between change in CEO wealth and
shareholder returns is one method shareholders
and stakeholders can use to determine whether
compensation contracts are appropriate.
2.While it is reasonable for a CEO to increase
wealth at a faster rate than shareholders (because
executives are asked to make strategic decisions),
it is not clear what the ratio of this relationship
should be. Should it be 1.5 times, 2.0 times, 2.5
times, etc? In all likelihood, the ratio should be
determined in the context of the company’s industry, competitive positioning, and risk appetite, as well as the size of the executive’s equity
holdings and tenure. 
According to a confidential survey conducted in 2005 by a major
HR consulting firm, the top measures used to determine the annual
bonus include profit measures (earnings per share, EBITA, net income, operating income, and pretax profit), return measures (return
on capital, return on assets, and return on equity), cash flow measures (cash flow, economic value added, and working capital), and
other measures (sales growth, customer satisfaction, product/service
quality, safety, and employee satisfaction). Typically, there is also a
subjective component for “individual performance.”
2
This assumes that shareholders measure performance in terms of
value creation and that executive decisions impact stock prices.
3
Julie Creswell and Michael Barbaro, “Home Depot Board Ousts
Chief, Saying Goodbye with Big Check,” The New York Times, Jan.
4, 2007.
4
Stock sales occurred between 2003 and 2007. Mark Maremont,
John Hechinger and Maurice Tamman, “Before the Bust, These
1
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2
Sensitivity of CEO Wealth to Stock Price: A New Tool for Assessing Pay for Performance
CEOs Took Money off the Table,” The Wall Street Journal, Nov. 20,
2008.
5
For example, James Kilts, CEO of Gillette, came under fire for receiving a severance package worth $185 million following the sale of
Gillette to Procter & Gamble in 2005. Less noted was the fact that
Kilts increased the value of Gillette by over $20 billion during his
four-year tenure, delivering annual returns of 14 percent compared
with negative 0.6 percent for the S&P 500. Sources: Graef Crystal,
“Kilts is the Real Winner in P&G Buying Gillette,” Bloomberg, Feb.
23, 2005; and calculations by the authors.
6
Includes the fair value of beneficially held stock and options (both
vested and unvested). In calculating stock option fair value, remaining terms are reduced by 30 percent to adjust for potential early
exercise or termination. Source: Equilar compensation and equity
ownership data for fiscal years from June 2008 to May 2009.
7
For simplicity, we use the term “convexity” to mean the percentage
return on the CEO’s equity portfolio for a 100 percent change in the
stock price. This is taking a bit of liberty with the pure mathematical
definition of convexity.
8
Since 2006, companies have had to provide detailed information
on each tranche of options held by named executive officers. Previously, options outstanding were pooled together. Disaggregation in
the disclosure allows us to precisely plot out the changes in value of
each, based on prevailing market prices.
9
Obviously, risk taking can be either good or bad for shareholders.
Firms are in business to take appropriate risk and generate the required returns for shareholders. Risk taking is negative when the risk
assumed by investment, financing, and operating decisions is excessive in relation to the potential return.
David Larcker is the Morgan Stanley Director of the Center
for Leadership Development and Research at the Stanford
Graduate School of Business and senior faculty member
at the Rock Center for Corporate Governance at Stanford
University. Brian Tayan is a researcher with Stanford’s Center for Leadership Development and Research. They are
coauthors of the books A Real Look at Real World Corporate Governance and Corporate Governance Matters.
The authors would like to thank Michelle E. Gutman for
research assistance in the preparation of these materials,
Christopher Armstrong and Gaizka Ormazabal for help
with computations, and Equilar Inc. for providing access
to the raw compensation and equity ownership data.
The Stanford Closer Look Series is a collection of short
case studies that explore topics, issues, and controversies
in corporate governance and leadership. The Closer Look
Series is published by the Center for Leadership Development and Research at the Stanford Graduate School
of Business and the Rock Center for Corporate Governance at Stanford University. For more information, visit:
http://www.gsb.stanford.edu/cldr.
Copyright © 2012 by the Board of Trustees of the Leland
Stanford Junior University. All rights reserved.
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Sensitivity of CEO Wealth to Stock Price: A New Tool for Assessing Pay for Performance
Exhibit 1 — CEO Wealth and Sensitivity to Stock Price Change
median
Firm Size
Top 100
Market Cap
($ thousands)
Total CEO Pay
($)
Total CEO
Wealth ($)
Δ Wealth
(1% change)
Δ Wealth
(50% change)
Δ Wealth
(100% change)
$36,566,000
$11,439,000
$48,758,000
1.26%
67.6%
139%
101 to 500
6,899,000
6,590,000
21,170,000
1.22%
63.1%
130%
501 to 1000
2,067,000
4,147,000
13,201,000
1.16%
59.7%
121%
1001 to 2000
636,000
2,168,000
8,129,000
1.09%
55.7%
113%
2001 to 3000
175,000
1,187,000
3,545,000
1.07%
53.9%
109%
3001 to 4000
35,000
623,000
827,000
1.06%
53.8%
109%
337,000
1,615,000
5,176,000
1.10%
55.8%
113%
1 to 4000
mean
Total CEO
Pay ($)
Total CEO
Wealth ($)
Δ Wealth
(1% change)
Δ Wealth
(50% change)
Δ Wealth
(100% change)
$60,793,000
$13,628,000
$1,080,493,000
1.33%
72.6%
151%
101 to 500
8,692,000
8,926,000
84,962,000
1.29%
71.9%
169%
501 to 1000
2,190,000
5,693,000
71,194,000
1.21%
63.3%
130%
1001 to 2000
707,000
3,002,000
33,841,000
1.15%
59.6%
122%
2001 to 3000
186,000
1,784,000
12,825,000
1.12%
58.2%
119%
3001 to 4000
39,000
947,000
2,602,000
1.09%
58.9%
122%
2,891,000
3,387,000
56,622,000
1.15%
61.1%
128%
Firm Size
Top 100
1 to 4000
Market Cap
($ thousands)
Note: Calculations exclude personal wealth outside company stock. Total CEO compensation is the sum of salary, annual
bonus, expected value of stock options granted, expected value of restricted stock granted, target value of performance
plan grants, and other annual compensation. Calculations for compensation exclude changes in pension. Stock options
are valued using the Black-Scholes pricing model, with remaining option term reduced by 30 percent to compensate for
potential early exercise or termination and volatility based on previous year actuals.
Source: Equilar compensation and equity ownership data for fiscal years from June 2008 to May 2009.
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Sensitivity of CEO Wealth to Stock Price: A New Tool for Assessing Pay for Performance
Exhibit 2 — Change in CEO Wealth: Exelon v. Southern Company
Exelon v. Southern Company
300%
Return to Shareholders and CEO
250%
200%
150%
100%
Shareholders
CEO - Southern Co.
50%
CEO - Exelon Corp.
0%
-50%
-100%
-100%
-50%
0%
50%
100%
Stock Price Return
Market Cap
($ thousands)
Total CEO Pay
($)
Total CEO
Wealth ($)
Δ Wealth
(50% change)
Δ Wealth
(100% change)
Southern Co.
28,659,000
2,246,000
3,620,000
110%
235%
Exelon
36,587,000
1,236,000
4,010,000
60%
123%
Dominion Resources
20,835,000
3,275,000
5,510,000
50%
100%
Company
Note: The graph shows the expected change in CEO wealth, given a change in company stock price. While shareholders
realize a 1-for-1 change in wealth with stock price, CEO wealth will vary depending on the mix of compensation. Compensation packages that include a heavier allocation of stock options will exhibit a steeper pay off, while those that include
a heavier allocation of restricted stock will exhibit a more linear payoff. Calculations exclude personal wealth outside of
company stock.
Source: Equilar compensation and equity ownership data for fiscal years from June 2008 to May 2009. Includes CEOs of
Southern Co Georgia Power, Exelon ComEd, and Dominion Generation.
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Sensitivity of CEO Wealth to Stock Price: A New Tool for Assessing Pay for Performance
Exhibit 3 — Change in CEO Wealth: Packaged Food Companies
General Mills v. Kraft
300%
250%
Return to Shareholders and CEO
200%
150%
100%
Shareholders
CEO - General Mills
50%
CEO - Kraft
0%
-50%
-100%
-100%
-50%
0%
50%
100%
Stock Price Return
Market Cap
($ thousands)
Total CEO Pay
($)
Total CEO
Wealth ($)
Δ Wealth
(50% change)
Δ Wealth
(100% change)
General Mills
16,837,000
10,118,000
13,710,000
138%
298%
Campbell Soup
13,515,000
9,784,000
74,240,000
108%
223%
Kraft
39,446,000
16,120,000
25,870,000
58%
118%
Company
Source: Equilar compensation and equity ownership data for fiscal years from June 2008 to May 2009.
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Sensitivity of CEO Wealth to Stock Price: A New Tool for Assessing Pay for Performance
Exhibit 4 — Change in CEO Wealth: Pharmaceutical Companies
Johnson & Johnson v. Pfizer
300%
Return to Shareholders and CEO
250%
200%
150%
100%
Shareholders
CEO - Johnson & Johnson
50%
CEO - Pfizer
0%
-50%
-100%
-100%
-50%
0%
50%
100%
Stock Price Return
Market Cap
($ thousands)
Total CEO Pay
($)
Total CEO
Wealth ($)
Δ Wealth
(50% change)
Δ Wealth
(100% change)
Johnson & Johnson
166,002,000
23,023,000
80,650,000
106%
226%
Abbott Labs.
82,807,000
27,977,000
119,820,000
100%
213%
Pfizer
119,417,000
10,378,000
18,630,000
82%
178%
Merck
64,271,000
16,291,000
21,730,000
78%
167%
Company
Source: Equilar compensation and equity ownership data for fiscal years from June 2008 to May 2009.
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