The Advisors' Blog

– Ira Kay and Steve Seelig, Watson Wyatt Worldwide

We read David Schmidt’s recent post on disclosure of performance targets with interest, and agree that companies have not done a great job (if they are doing any job at all) of disclosing “degree of difficulty” when actual goals are not disclosed. And Corp Fin Director John White himself was similarly unimpressed when he stated after the end of the 2007 proxy season: “Without more, identifying a target simply as ‘challenging but achievable’ or as ‘designed to promote excellence and motivate management’ seems an empty disclosure that I would not think is useful to investors.”

While the use of such catch-phrases is not what the SEC is looking for, part of the blame for them not seeing a better analysis must rest on the SEC’s lack of guidance in this area. The rules simply don’t provide sufficient guidance for how companies should assess “degree of difficulty” in order to “discuss, in a meaningful way, how difficult it will be for the executive or how likely it will be for the company to achieve that target.”

We’ve made this point to the SEC in a comment letter earlier this year, and are hopeful it takes the time to provide more guidance on this issue. In our letter, we detail a methodology we first developed when advising Compensation Committees who asked us to help assess the “degree of difficulty” of performance goals being presented to them by management for their approval.

It works something like this, assuming for this example a company has established an annual sale growth target of 10 percent in its bonus plan:

1. Review goal against historical company and peer median performance – Whatever the metric chosen (e.g., annual sales growth), determine the extent to which the company has performed versus its peers. To illustrate, assume the company has outperformed the peer group for many years, with a mean over 10-years that was 13 percent versus 10 percent for the peer group.

2. Review goal against historical probabilities based on a peer group performance – Calculate descriptive statistics on the data set (e.g., mean, median, mode, standard deviation) to show historically how likely hitting certain targets would be. For example, 20% of the time companies achieved a 0-5% annual growth in sales, while only 6.7% percent of the time did they achieve 20-25% annual growth, etc.

3. After observing the shape of distribution and various descriptive statistics, examine how a specific goal fits within the distribution – For a targeted sales growth goal of 10 percent, there would be an approximate 50 percent probability of achieving this based on historical peer performance.

4. Review analyst estimates – Markets are inherently forward-looking. However, many companies set goals based on prior performance only. We think historical data is helpful but can be enhanced significantly by incorporating forward-looking estimates into the process. By incorporating consensus analyst estimates, we provide an additional lens to view performance.

5. Consider stock price to understand long-term expectations – This balances with the use of short-term (2-3 year) analyst expectations compiled in Step 4 by taking a longer term view. We use a discounted cash flow model to gauge long-term expectations. For example, to gauge the stock market’s expectation for sales growth, we use market-based assumptions (from Value Line or other sources) for all inputs except sales growth. We then modify the sales growth rate to determine the sales growth that generates the current stock price.

While we do not necessarily advocate disclosing a probability percentage in the CDA, due to the potential that the plaintiff’s bar would seize on these disclosures in future litigation, we would strongly advocate companies disclose the methodology they used in concluding their goals are “challenging” etc. Remember, John White did not say the words themselves are inadequate, he said using words “without more” is problematic. Our approach gives companies the “more.”

One other point in David’s post gave us pause, which was the notion that:

Companies may be choosing not to disclose specific benchmarks because those figures may be significantly different from financial targets that executives at these corporations have promised Wall Street analysts and investors — indicating that the boards in question are setting their bars too low and generating bonuses too easily.

Actually, we think the issue is the other way around. We believe companies tend to provide forward looking guidance to analysts that is conservative or attainable, whereas the goals within the bonus plans more accurately reflect the actual targets Boards expect management to attain. We believe part of the reason companies are reluctant to disclose the higher goals in the bonus plan is precisely because they are harder to attain, and that analysts might increase their forecasts – and downgrade the companies if they were not hit.