A study in relativity

Business Times - 02 May 2009

The basis for compensation should be the incremental value leaders bring on a per population or per share level, By TEH HOOI LING SENIOR CORRESPONDENT

EVERYTHING is relative. It's an indisputable truth. Generally we cannot take an absolute number and make a value judgment based on that alone.

Take two apartments, for example. One costs $1.5 million and the other $1.2 million. Which is cheaper? Well, we can't say until we know how big each one is, which floors they are on and which district they are in.

Numbers do take on a new perspective when you relate them to something else. In December 2006, Hong Kong financial guru Marc Faber noted that it took fewer than 10 barrels of oil to buy one ounce of gold - and that, according to him, was an indication that gold was cheap compared with oil. At the time, gold was trading at around US$600 an ounce, and oil at just over US$60 a barrel.

In 1999, it took more than 25 barrels of oil to buy an ounce of gold. The average over the 10 years prior to 2006 was around 15 barrels.

Until today, Dr Faber has been proved right - gold was cheap back in 2006. In the past 28 months, the price has risen about 40 per cent to around US$900 now. Oil, meanwhile, surged to a high of US$144 a barrel in July last year before collapsing all the way down to US$36. It is now trading around US$50.

At today's price, it takes 18 barrels of oil to buy one ounce of gold. So if the relative pricing of the two commodities still holds, one can surmise that either gold is now slightly on the high side, or oil is on the low side.

Now let's talk about pay - a very contentious issue these days. Early last month, The Australian newspaper ran an article on the 10 best-paid politicians in the world. Topping the list was Singapore's Lee Hsien Loong at US$2.47 million a year. In the second position was Hong Kong's Donald Tsang, at US$516,000. Barack Obama, who has just marked his 100th day as the President of the United States, earns US$400,000.

Ireland's Brian Cowen and France's Nicolas Sarkozy make US$341,000 and US$318,000 respectively. Tenth on the list was Australia's Kevin Rudd, at US$229,000.

But The Australian pointed out that if you look at the pay relative to the size of the country run by each of the 10 politicians, you would see things in a different light.

'If you divide the salary by head of population, the ladder of remuneration is significantly reshuffled, and our own Prime Minister leaps from 10th to fourth, while Obama slides from third to 10th,' the article said. 'So by this measure, Rudd is earning roughly 10 times what the US President is.'

Based on that measure, Singapore's Prime Minister Lee Hsien Loong still tops the list.

But here's the key question. Are heads of states overpaid? I say they are not. Their compensation pales in comparison with that of corporate head honchos. For instance, Mark Hurd, the chief executive of Hewlett-Packard, was paid US$42.5 million in 2008. And in 2007, CEOs of S&P 500 companies were paid an average of US$10.5 million a year.

Relative to the responsibility that political leaders face - the livelihoods and social well-being of millions depend on their decisions - I think their pay is too low.

Well, what are the justifications for the astronomical sums paid to top executives? In Singapore, the compensation of CapitaLand chief executive Liew Mun Leong came under scrutiny recently.

Mr Liew was paid $20.52 million bonus for 2007, followed by a comparatively modest $2.98 million for 2008. CapitaLand said the 2007 figure was due primarily to an economic value added (EVA) bonus payment. Essentially, EVA measures the group's net operating profit after tax, minus the cost of all capital employed. CapitaLand's EVA was $2.3 billion in 2007, and $660 million in 20080.

Mr Liew pointed out that his $20.52 million bonus for 2007 worked out to 0.74 per cent of the company's net profit, which hit a record $2.76 billion that year. In contrast, the average bonuses drawn for the 2007 financial year by the chief executives of Singapore's 10 biggest listed companies came to a larger 3.9 per cent.

Is EVA a fair measure of the benefits accrued by all shareholders, and therefore a reasonable metric to use when deciding an executive's compensation?

There are, of course, numerous criticisms of EVA as a measure of how well a company has performed. Take two companies. Company A has chalked up a return on capital of 13 per cent on its weighted average cost of capital (WACC) of 8 per cent, and Company B has returned 7 per cent on a WACC of 6 per cent. Obviously, on a return-on-capital basis, Company A has used its capital in more profitable projects and has created more value for its shareholders.

However, had Company B deployed a significantly larger amount of initial capital, say, $2 billion, compared with Company A's $100 million, its economic value added or EVA would have been larger, even though its overall return on capital is lower.

One per cent of $2 billion is $20 million, while 5 per cent of $100 million is only $5 million. So if an executive's compensation is based on EVA, the incentive is to try to grow the company as big as possible and seek to earn slightly above the cost of capital.

And if management grows the company by raising more capital from existing shareholders, the new capital will still be earning a 7 per cent return. Furthermore, if management decides to get a capital injection from new investors, existing shareholders may suffer dilution unless the return on capital is maintained.

So while EVA translates to the addition of firm value, the real goal for managers ought to be 'addition of firm value on a per share basis'.

Another criticism of EVA is the importance placed on a precise WACC. The cost of equity in the WACC calculation is derived from the Capital Asset Pricing Model, or CAPM, which some argued is flawed.

The usefulness of EVA aside, let's get back to the question of relativity. Mr Liew earned a $20.52 million bonus, and the CapitaLand group has about 10,000 employees. So his bonus was a whopping $2,052 per person he managed. Remember, Mr Obama makes 0.1 of a US cent per American citizen.

On the other hand, Mr Liew's bonus represented a mere 0.74 per cent of CapitaLand's net profit. He himself noted that the 3.9 per cent average figure was for the CEOs of the 10 largest locally listed companies.

However, if Singapore's Prime Minister were to get 0.74 per cent of the country's GDP - and managing a country is similar if the end-game is GDP growth - Mr Lee should be paid $1.9 billion based on Singapore's 2008 GDP of $257.4 billion. As for Mr Obama, his pay should be US$105.5 billion.

So obviously, a country's GDP - and arguably a company's net profit figure or EVA - should not be the basis to derive the compensation of a head of state or the head of a company. The basis should be the incremental value they bring on a per population or per share level.

Jason Wee, a former analyst with CLSA, suggested in a recent article in Pulses magazine that besides linking the pay of Singapore's leaders to the average of the nation's best-paid individuals, one might also set a cap on this, based on a multiple of the income of the nation's bottom 20 per cent.

'This multiple can be set at some reasonable level without being excessively onerous, so that future leaders, in pursuit of higher quantitative metrics, will never forget about the less well-off in Singapore,' Mr Wee wrote. To get higher pay for themselves, the leaders should have to bring up the rest. This, I think, would also have the effect of making them continually aware of the harsh reality of the poorest people in the community.

Similarly for the private sector, compensation can be made relative to market share gained, earnings per share growth or a company's long-term sustainable growth. Also, there should be a cap, which could be based on, say, a multiple of the pay of the bottom 20 or 30 per cent of employees. Then, the bosses would be well aware of what life is like down the ranks.

As we have seen, relativity - used correctly - can give added perspective; but pegged to a wrong figure, it can lead to preposterous conclusions. And that is one of the reasons the world is in such an economic mess today.