The Use of TSR in Executive Incentive Compensation


Given the vast changes in the market since March, corporate boards and shareholders are faced with urgent questions on how to address executive compensation during times of crisis. Many market participants believe that the primary driver of current stock market growth is the Federal Reserve’s forceful slew of interventions to blunt some of the effects of the on-going economic crisis. In addition to other doubts cast upon the soundness of using Total Shareholder Returns (TSR) in executive incentive compensation, should executives be rewarded based on shareholder returns from shares that are trading at potentially distorted prices due to the Fed’s intervention in the market? Is that rewarding true value creation or instead the equivalent of giving out a participation trophy?

Combined with the difficult optics surrounding executives receiving incentive compensation as thousands of employees are laid off, these factors mean that now is the time for boards to consider reducing their reliance on TSR as the main executive incentive compensation metric and significantly increasing the weight given to metrics that incentivize operational value creation such as Economic Value Added, or EVA®.

Why TSR and TSR Prevalence in Incentive Compensation

TSR has been touted by its supporters as an objective, shareholder-focused way to reward management for aligning interests and creating value for shareholders; it is seen as the best way to shift to performance pay and be seen as listening to negative say-on-pay reactions by voting shareholders.

Undoubtedly, TSR is the popular kid on the block today. Exequity's analysis of executive compensation in 2019 showed that 58 percent of companies on the S&P 500 use TSR in their incentive plans, an increase of 3 percent in one year since 2018. The average weight attributed to TSR for incentive compensation ranges between 55-69 percent.¹ This data shows us that currently TSR remains a highly influential, pervasive, and important measure in determining compensation for most of corporate America.

TSR’s Limitations 

Despite this popularity, TSR is plagued by some intrinsic limitations. The primary limitations of TSR are 1) that it is highly influenced by exogenous factors outside of the control of a company’s management; 2) it does not indicate to management how to influence performance to lead to strong TSR; and 3) there is evidence that its inclusion in incentive pay does not lead to better performance.

Joel Stern, founder of Stern Value Management, would often cite a doctoral thesis done by his colleague at the University of Chicago showing that approximately half of share price movements are due to macro-economics, approximately one-quarter are due to industry climate, and only about one-quarter due to management’s performance.

Given that TSR is so affected by external factors, many have pivoted to using industry peer-sets in an attempt to mitigate these effects. Even with these peer-sets, short-term and non-material share price fluctuations can distort the true performance of a company during the period analyzed. These can be largely affected by analyst’s opinions, life-cycle stage of the company, competition, expectations for the future, and many more variables that are not under the control of executives. Further, TSR over the time frames it is usually measured, three to five years, can put into tension strong financial performance and shareholder returns:

“…[D]isconnects can arise over shorter periods of time. In any finite period, strong financial performance does not translate to strong shareholder returns — in some cases due to exogenous factors, and in others due to increasing investor expectations. These disconnects can become compounded when measuring relative market performance, because the factors and variables for one company extend to all companies within the comparator set [emphasis added].”2

In addition to the difficulty of extracting the exogenous variables from management's performance, TSR does not tell management how to effect further strong TSR. It is difficult, if not impossible, to trace a particular management decision directly to a strong TSR, even if just examining the portion of TSR that is under management's control. If TSR cannot inform management of what leads to improvised TSR, how can it properly incentivize any particular value-creating behavior?

Finally, there is a growing body of evidence that the use of TSR in incentive pay does not lead to better performance. Companies that are larger and less-profitable are more likely to shift to TSR as an incentive pay metric. Summed up by a study from Cornell University's Institute for Compensation Studies, "Including TSR in a long-term incentive plan does not lead to improved company financial performance."

Why Current Monetary and Fiscal Policy Makes TSR Even Less Relevant to Management’s Performance

We are currently witnessing unprecedented intervention of the Federal Reserve into the national and world economy. The ongoing massive monetary stimulus is accompanied by an equally mind-boggling fiscal stimulus, which includes interventions such as targeted bailouts, grants, PPE, etc.

A recent poll showed that a vast majority of market participants thought that the Federal Reserve is the principal reason why the stock market is continuing its fast, upward recovery from March lows. If we consider that TSR is so heavily influenced during normal times by exogenous factors, what does that imply about the effect of the Fed and fiscal policy on TSR right now, in this environment, which is hypersensitive to government intervention?

If we dig deeper, we see that decisions such as accepting PPE, grants, and bailouts, even if we control for broader market effects and only consider a sector or industry, have disproportionate effects on a company’s share price movements. This seems unlikely to be a short-term effect either, calling further into question the utility of even three-to-five year TSR given the current and near-term economic climate.

If Not TSR, Then What?

If TSR is not the ideal metric for use in incentive pay compensation, then what is? The answer is, EVA as it represents the true economic profit above the cost of capital that a company created in a given year. Unlike TSR, EVA should be applied to not only the corporate entity level, but to individual capital allocation decisions for projects, thus indicating to management where to focus in order to continue value creation.

EVA, when used properly and examined as the change in EVA over time, is unlike TSR in that there is never a potential disconnect between true value creation and shareholder value creation. A positive delta EVA always means that value was created for shareholders (even if it goes from a negative EVA to a less negative EVA, since only delta EVA matters), while a negative delta EVA always means destruction of value for shareholders.

Finally, EVA has been demonstrably proven to lead to superior performance outcomes. Clients who have adopted and announced their adoption of VBM - Value Based Management™, grounded in EVA, have had superior returns amounting to almost 90 percent above the MSCI World index between 2009 and 2019.


TSR, while popular among today's corporations for use in incentive pay, has serious intrinsic limitations that makes it a poor option as a primary driver of executive incentive compensation. The current monetary and fiscal interventions of the Federal Reserve are further distorting the market and rendering TSR, even when adjusted for industry, less representative of management performance. Given these changes, EVA should supersede TSR as the metric used by boards for incentive compensation. EVA is a superior alternative to incentivizing management, with a strong theoretical foundation that links to true value creation, a tangible track record of delivering results above the market, and an effective and understandable system for aligning the interests of executives with shareholders.

¹Exequity Client Brief, 2019 Relative TSR Prevalence and Design of S&P 500 Companies. Published 09/2019

2The Problem With Relative Total Shareholder Returns by Todd Sirras and Barry Sullivan. Published in WorkSpan 05/2012

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