The Advisors' Blog

Mike Kesner’s recent posts on relative performance measures and peer group selection led to a spate of emails among our consultants at Watson Wyatt. Yes Broc, folks do read this blog! Here is our collective group-think, as articulated by Michael Marino, one of our consultants who focuses his practice in these areas:

Relative performance measures give the appearance of objectivity and simplicity but are very difficult to implement correctly for two reasons:

1. Identifying performance peers is a significant challenge and many firms underestimate this challenge.

2. Metric definitions can vary significantly and they are often adjusted from GAAP accounting to reflect specific factors unique to a particular company.

Peer Group Challenges: Business economics are often very different within a single sector or industry and executive performance peer groups often do not reflect these economics. For example, in the petrochemicals industry, upstream, midstream, downstream and fully integrated companies will have very different business economics. It is difficult to find two or three companies that have highly comparable businesses in any sector, let alone 10 or more, which is a common number for relative performance assessment.

Investment bankers and investment managers understand the limitations of peer groups as a valuation method. This is why they rely on multiple valuation approaches to assess business value. Executive performance assessments should recognize this limitation and should be more robust than simply measuring relative performance (see solution below).

Accounting and Financial Reporting Challenges: Financial metric definitions are often inconsistent between companies and they are often measured on a non-GAAP basis. It is very difficult and sometimes impossible to put companies on equal footing if a company uses a non-GAAP measure for incentive compensation purposes. In many cases, the non-GAAP measures reflect adjustments aimed at removing accounting distortions to better focus on business operations.

Consider also the effect of acquisitions on business performance and relative comparisons. Acquisitions can boost revenue growth and reduce return measures in the short-term thereby distorting performance in the short-term when the benefits of the acquisition are still uncertain.

One Solution: We recommend that our clients counterbalance absolute and relative goals in incentive plan design. Consider measuring absolute financial performance and relative financial performance on the same measure (e.g., absolute EPS and relative EPS) Companies should also consider balancing absolute financial performance with relative stock price performance or TSR. This way, operating performance is viewed in the context of the market’s expectations for future financial performance.

– Ira Kay and Steve Seelig, Watson Wyatt Worldwide