Setting financial targets in a high-stakes environment.

• Author: Ericson, Richard N.
• Position: COMPENSATION

The stakes placed on corporate financial performance standards are enormous. In this option-expensing era, companies are making far more extensive use of long-term incentives that hinge on explicit goals. These include performance share plans, performance cash plans, goal-contingent forms of stock options and restricted stock and formula-based phantom stock.

While annual bonus pay has always been important and heavily dependent on pre-set financial goals, long-term incentive grants are a much bigger potential source of rewards for senior management today.

Compensation committees are demanding more data and testing, particularly outside benchmarks. The rest of the board is also highly interested, driven by greater concerns about business uncertainty and risk management. Board members want not only a more strongly vetted case for the central forecast, but more rigorous scenario-testing.

Companies typically use budgets or other standards determined internally to set performance targets in an incentive context. This means management can get paid for managing expectations as much as for managing the business. At many companies, aggressiveness is penalized from an incentive standpoint because aggressive goals simply raise the bar for a given pay opportunity. The process is often seen as unfair and important resources--capital and management time--may be misspent.

Financial target-setting does not have to be an anchorless, strictly insider process. A typical company is surrounded by information sources that can be relevant. And the process can be improved by compiling multiple indicators and reconciling them. There's no magic bullet. But in practice, companies can apply a range of procedures to set goals.

Standard-setting References

For many organizations and boards, three main external benchmarks should be consulted:

1. Historical financial and valuation metrics for the company and peers. Past growth rates for revenue and income may or may not provide a projectable trend. However, norms for indicators like capital turnover, margins, return on invested capital and free cash flow often can help to govern forecast assumptions. Stock market performance is also worth a look. If past results were accompanied by unusually low total shareholder return (TSR), then that performance level may have been below applicable standards and it may be so on a going-forward basis.

2. Analyst predictions. Analyst reports provide industry commentary along with forecasts of revenue, earnings per share and other metrics. Analysts do not offer perfect insight, of course, and users of these data should be on guard for bias. But consensus forecasts often are meaningful.

   Stock prices usually...