Bridge over ocean
1 November 2013 CFA Institute Journal Review

The Profits Prophet (Digest Summary)

  1. Natalie Schoon

The change in managerial pay from salary based to bonus based may have unintended consequences. The subsequent short-termism that comes with bonus-based pay results in low investment in business and high price volatility.

How Is This Article Useful to Practitioners?

Although profits have recently been booming in the United States and elsewhere, the ratio of business investment to GDP is still around the low levels of previous cycles before the financial crisis. Companies are instead choosing to buy back shares. In 2011, for example, the value of US share buybacks was approximately 2.7% of GDP and 3.1% in the United Kingdom. Currently, US companies invest less than 2 times as much money as they distribute to shareholders, compared with 15 times as much in the early 1970s.

There are a number of underlying causes, with one of the main ones being the change in executive pay from salary based to bonus based. Bonuses are typically tied to the share price, which is, in turn, tied to the ability of the company to meet its quarterly target for earnings per share (EPS). Contrary to investments, share buybacks have a positive impact on EPS.

Rewarding managers with options negatively affects price volatility because options are more valuable when linked to a volatile asset. Thus, managers are incentivized to pursue strategies that increase the volatility of profits, typically focusing on high margins in the short term and ignoring the potential future loss of market share.

Unusually poor productivity numbers in the United States and the United Kingdom in recent years because of the addition of labor instead of capital, overstatement of profits and net worth attributable to mark-to-market accounting, and the lack of a reduction in the non-corporate debt-to-GDP ratio—all lead to an underestimation of the danger of high debt. Thus, a collapse in asset prices could still provoke a crisis.

Abstractor’s Viewpoint

The author provides some insights from a newly published book and raises interesting points regarding productivity and managers’ salaries, although the author of the book seems to remain quiet on the sustainability of this situation. Maybe the troubles in the financial industry are not just the banks’ fault after all.

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