Management Incentives

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One important reason why around 60% of global stock market capitalization is concentrated in the United States is well illustrated by the chart below.

In the U.S., top management is paid more than in most other markets, and a larger share of compensation comes from long-term incentives — mainly shares and stock options. But this is not the whole story.

Compensation through shares and options has several weaknesses:

1. Share prices are heavily influenced by market and industry conditions.
Many of these factors are outside management’s control. Therefore, a rising share price does not automatically mean good management — and a falling share price does not automatically mean poor management.

2. Current share prices already reflect expectations about management quality.
If the market already expects management to generate strong profits, then even good results may not increase the share price.

3. Share-price-based incentives can create temptation for manipulation.
Management may be tempted to exaggerate temporary positive events, hide negative developments, or manage investor perception instead of managing the business.

For these reasons, a significant part of management compensation is often also tied to accounting and economic profit measures. This part tries to evaluate management’s actual operating performance.

In simple terms:

Shares and options tell management:
“We are in the same boat.”

Bonuses based on economic profit ask:
“How well is the captain managing the boat?”

One widely used measure, popularized by the consulting firm Stern Stewart, is EVA® — Economic Value Added.

The basic idea is:

EVA = Residual Income = Income Earned − Income Required

Or more practically:

EVA = Income Earned − Cost of Capital × Investment

Different management consulting firms offer different versions of this formula, but the core idea is the same:

The goal is not to measure accounting profit alone, but the part of profit that exceeds the opportunity cost of capital.

This changes management’s mindset.

Instead of thinking only about increasing profit, management starts thinking about increasing the value of the company. They begin to search for positive-NPV projects, because negative-NPV projects may increase accounting profit, but destroy business value.

The problem is that traditional accounting does not fully reflect the cost of capital.

That is why this type of incentive system sends a very powerful signal to management:

Assets are not free.
Capital has a cost.
Investments must go into the right assets.
Negative-NPV assets should be removed quickly.

However, this approach also has an important weakness.

Accounting does not always provide accurate economic information — especially when it comes to depreciation.

Therefore, if a company decides to implement such a system, accounting depreciation should ideally be replaced by real economic depreciation or market-value-based estimates.

At minimum, depreciation formulas should be adjusted so that they are closer to economic reality.

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Photo and ideas from:
Principles of Corporate Finance — F. Allen, R. A. Brealey & S. Myers