Munich, January 7, 2020

Pay for performance – What is performance?

Prof. Dr. Christian Aders

Pay for performance – What is performance?

2

Source: The Wall Street Journal, May 3, 2016.

Agenda

Table of content

1. Basic principle of performance measurement and compensation

2. Performance from the shareholders‘ perspective

3. Performance from the management’s perspective

4. Value-based performance measurement on the basis of value/book value based target returns

ValueTrust Financial Advisors SETheresienstraße 1

80333 Munich

Germany

www.value-trust.com

3

Basic principle of performance measurement and compensation

1

Basic principle of performance measurement and compensation – theory

Investor(Principal)

Management (Agent)

Incentive compatibility through compensation contracts

5

▪ Reduction of the Principal-Agent dilemma and creation of incentive compatibility between investors and management through compensation contracts

Conclusion

Information asymmetry

Basic principle of performance measurement and compensation – common practice

„Human beings adjust behavior based on the metrics they‘re held against. Anythingyou measure will impel a person to optimize his score on that metric. What youmeasure is what you‘ll get.“

Source: Dan Ariely, Harvard Business Review, June 2010.

6

▪ What is performance from the perspective of the shareholders?

▪ What is performance from the perspective of the management?Conclusion

Performance from the shareholders‘ perspective2

Shareholders measure the performance of their investment resp. of the company by means of the Total Shareholder Return (TSR)

8

▪ For the assessment of the actual performance, the TSR must be evaluated in relation to the actual performance of the benchmark and the planned performance

Conclusion

(Closing stock price – Opening stock price) + Dividends

Opening stock priceTSR =

Dividend yield

Share performance

TSR

Plan/actual performance of the benchmark using the capital markets of the DACH region as an example

Source: ValueTrust

9

▪ The ATX/DAX/SMI companies realized an average TSR of about 9.0% in the last 4 years

▪ The implied cost of equity (= expected TSR), derivable from the stock prices and net income estimates, currently amount to about 9.2% for the ATX/DAX/SMI

Conclusion

Implied market return & TSR – ATX/DAX/SMI

9,4% 9,7% 9,6% 10,9% 10,4% 9,5%8,8% 8,3%

7,8%8,3%

7,8% 8,0% 8,1% 7,9%

12,9%

10,6%

0,0%

2,0%

4,0%

6,0%

8,0%

10,0%

12,0%

14,0%

16,0%

H1 2010 H2 2010 H1 2011 H2 2011 H1 2012 H2 2012 H1 2013 H2 2013 H1 2014 H2 2014 H1 2015 H2 2015 H1 2016 H2 2016

Implicit market return & TSR - ATX/DAX/SMI

Range (25% - 75% Quantil) of the impl. market return Market value-weighted mean of the impl. market return Ø TSR 2010-16 Ø TSR 2013-16

If the shareholders' expectation, which is included in the stock price, are met, the actual performance equals the cost of equity resp. the expected TSR

Cost of equity

Shareholders‘ expectation

regarding company

performance

= Actual company performance =

Total Shareholder Return (TSR)

! !

10

▪ How can the shareholders‘ performance expectations be exceeded? Question

Outperformance from the shareholders‘ perspective is „Under promise and/or Over perform“ from the perspective of the management

Shareholders‘ expectation

regarding company

performance

= Actual company performance

RealizedTSR

=Originally

expected cost of equity

Management of shareholders‘ expectations

Outperformance of “internal“ targets

Excess return for

shareholders

11

▪ In order to generate excess return for the shareholders, management must exceed the shareholders‘ expectations

▪ If this leads to an adjustment of the shareholders‘ expectation (and share performance), the „Expectations Treadmill“ will start

Conclusion

The Expectations Treadmill is difficult to beat in the long term and can lead to disincentives

* Source: Koller / Goedhart / Wessels: Valuation (2015), p. 50 f.

„If the company beats expectations, and if the market believes the improvement is sustainable, the company‘s stock price goes up, in essence capitalizing the future value of this incremental improvement. This improves TSR.

But it also means that managers have to run even faster just to maintain the new stock price, let alone improve it further: the speed of the treadmill quickens as performance improves.“*

12

▪ For every performance enhancement, which will be priced in the current stock price, management has „to run even faster“, in order to achieve additional excess return (Expectations Treadmill)

Conclusion

55%40%

30%

45%60%

70%

0%

20%

40%

60%

80%

100%

CH A D

Ja Nein

After all, the ex post realized TSR is frequently used in practice as KPI for the management compensation (example DACH region)

13

Source: ValueTrust analysis based on the annual reports 2015; * Note: the compensation structure of CA Immobilien (ATX) cannot be determined

TSR as performance indicator in the DACH region (SMI/ATX/DAX)

▪ No explicit TSR target (neither absolute nor relative) is used by the companies in the DACH region

▪ Between 10% (DAX) up to 30% (SMI) of the companies report the TSR as performance indicator

TSR as compensation indicator in the DACH region (SMI/ATX/DAX)

ValueTrust analysis

▪ In the SMI the TSR is applied on 55% of the 20companies within the scope of a compensationprogram. A peer group comparison is mainly used

▪ The TSR is integrated in a compensation program for 8of the 20 ATX companies (40%). For 5 companies arelative performance measurement featuring a peergroup as benchmark is used. For two companies a indexis used as a benchmark*

▪ 30% of the 30 DAX companies have integrated the TSRin a management compensation program

Yes No

In the US the TSR is currently the dominant indicator for the management compensation

Meridian Corporate Governance & Incentive Design Study 2018

Target setting

* Absolute and relative TSR

14

Usage of the relative TSR in US companies

Applied compensation indicators in US companies

▪ 200 listed US companies („Meridian 200“) were examined

▪ For the performance measurement by means of the relative TSReither a market index or a peer group comparison is used as areference

▪ If the TSR is used, it is the sole performance indicator in 18% ofthe cases and it is used parallel to several performance indicatorsin 82% of the cases

82%

12%

8%

64%

36%

Yes

No

6%6%

88%

Multiple one-year targets

Multiannual targets

One-year targets with Vesting

Net incomeRevenueTSR* Operating income

Profitability indicators

OtherEPS

26%

Cash Flow

64%

30%

44%

21%17% 16%

4%

The TSR correctly measures the performance from the shareholders‘ perspective but is problematic for the performance measurement of the management

„ExpectationsTreadmill“

Definition peer group (in case of relative TSR)

Time horizon measurement TSR (in case of multiannual TSR)

Mispricing of stocks (Speculation & value gaps)

Problem area of the TSR performance measurement

General capital market fluctuations

(e.g. Brexit, QE, etc.)

15

▪ The usage of the TSR as sole indicator for the performance measurement is not advisable

▪ The TSR is in particular relevant for the development of targets resp. „Stretch Targets“ for value optimizing corporate planning

Conclusion

Integration into company internal

performance indicators(Portfolio Management)

Performance from the shareholders‘ perspective (TSR) and from the management’s perspective (TVR) have to be differentiated initially and only randomly match

16

▪ The Total Shareholder Return (TSR) illustrates the return that is achieved on the market capitalization from the shareholders' perspective

▪ The Total Value Return (TVR) computes the periodic return on the intrinsic enterprise value from the perspective of the management

Conclusion

Dividend yield

Share performance

Total Shareholder Return (TSR)

Dividend yield

Return from an increase of the intrinsic valueTotal Value Return

(TVR)

Performance from the management’s perspective3

Performance from the perspective of the company aims at sustainable increase of the intrinsic value and closure of value gaps

Time

Intrinsic value/ stock price

Goal to permanently increase the intrinsic value

The stock resp. market price fluctuates around the intrinsic value

Through capital market communication the range of fluctuations decreases

Value gaps

Intrinsic value

18

▪ To increase the market valuation through the stock market resp. the stock price is, a sustainable growth of the intrinsic enterprise value is necessary which requires value optimizing business planning

Conclusion

Value optimizing planning und target setting requires the analysis of the value drivers implied in the current market valuation

GrowthReturn on Equity/Capital(ROE / ROIC / ROCE)

Excess return (Value Spread)

19

▪ The company strategy, the TSR expectations of the shareholders and the performance of the competitors resp. of the peer group determine whether there is potential for value enhancement the company

Conclusion

Fundamental value drivers

!Value Spread

Analytically the TSR and the value drivers cost of equity, value spread and equity/capital return (ROE, ROIC und ROCE) correlate functionally and link shareholder (external) and company (internal) perspective

20

Dividend yield

TSR

Cost of capital

=

Dividend policy

Anorganicinvestments

Organic investments

ROE / ROIC / ROCE

Share performance

Growth

External Internal

Cost of equity

Positive correlations can be verified also empirically between TSR resp. market-to-book-ratio and value spread for the capital markets of the DACH region

Equity Value Spread vs. TSR Equity Value Spread vs. M/B

Note: ValueTrust analysis.

21

▪ TSR and equity return benchmarking with the „Best Practice“ peer group is necessaryConclusion

ValueTrust analysis

y = 14,035x + 1,6252R² = 0,5519

0,0x

1,0x

2,0x

3,0x

4,0x

5,0x

6,0x

7,0x

8,0x

9,0x

10,0x

-20,0% -10,0% 0,0% 10,0% 20,0% 30,0% 40,0% 50,0%

Ø M

/B 2

01

3-2

01

8

Ø Equity Value Spread 2013-2018

y = 0,592x + 0,081R² = 0,2052

-30,0%

-20,0%

-10,0%

0,0%

10,0%

20,0%

30,0%

40,0%

50,0%

-20,0% -15,0% -10,0% -5,0% 0,0% 5,0% 10,0% 15,0% 20,0% 25,0% 30,0%

Ø T

SR

20

13

-20

18

Ø Equity Value Spread 2013-2018

TSR and peer group benchmarking is necessary for the validation of the ambitions of the business plan („Stretch Target“)

Current market expectation with

regard to TSR resp. cost of equity

andplanned ROIC resp.

growth

Benchmarkingwith peer groupwith regard to

TSR, ROIC,growth

22

▪ The reconciliation of the current market valuation with the strategy resp. planning of the management and with the performance of the competitors allows to question the feasibility and ambition of the company planning

Conclusion

Currentintrinsic

EnterpriseValue

„Target“-Enterprise

Value

Capital productivity (ROIC / ROCE)

Profitability (ROS)

Corporate portfolio / growth (g)

Capital structure und tax policy (WACC)

Val

ue

dri

vers

Value-based performance measurement on the basis of value/book value based target returns

4

Value optimizing performance measurement links shareholder and management perspective

Planned figures derived from value optimizing planning include TSR expectations

Performance measurement of equity returns on

the basis of plan/actual comparison and through

benchmarking with a „risk equivalent“ peer

group is a robust and incentive compatible

approach*

24

▪ Attaching the performance measurement solely to the plan/actual comparison, neglects unexpected environmental influences and incentivizes conservative planning („Gaming“)

▪ Relative performance measurement in comparison to the risk equivalent peer group can reduce the impact of unexpected and uncontrollable environmental developments

Conclusion

* Source: Velthuis / Wesner: Value Based Management (2005), S. 77 f.

Plan cash clow T

Plan cash flow n

Plan Cash Flow T

Plan cash flow 1

„Target“enterprise

value

t

(Detail) planning horizon

Planreturn n

Planreturn 1

Planreturn

vs.

vs.Actualreturn peer group

Performance measurement

Actualreturn company

The value/book value ratio is the transmission mechanism between shareholder and management perspective

25

Benchmarking with peer group

Shareholder expectation (TSR)

Actual returncompany

Actual return peer group

Strategy & company planning

Shareholder perspective Management perspective

Target return (book value)

value/book value

ratio

„Target“ Enterprise Value

The „target“ value/book value ratio determines the target return

26

* Simplified without growth in the terminal value model

Value/book valueratio

Target return

Cost of capital

„Target“ value spread* Price/book value

ratio

Target market value

Book value

„Target“ Enterprise Value

Book value

▪ Value optimizing target setting and performance measurement manifests in the setting of target returns on the basis of a intrinsic „target“ enterprise value

▪ In order to close value gaps resp. undervaluation the value/book value ratio and the market(price)/book value ratio have to converge

Conclusion

!

Shareholder perspective Management perspective

Discover our unique profile:

www.value-trust.com

Prof. Dr. Christian AdersSenior Managing Director

P: +49 89 388 790 100M: +49 172 850 4839

christian.aders@value-trust.com

Contact: