Throughout this spring, shareholders generally expressed their pleasure with 2013’s bull market by heartily endorsing the compensation of most companies’ top executives in 2014 say-on-pay votes. (For our latest say-on-pay update, see “Multiple Say-on-Pay Failures Reveal Some Common Themes,” Executive Pay Matters, May 22, 2014.) But, 2014 got off to a tenuous start, which could complicate the pay-for-performance picture if things don’t turn around in the remaining months of 2014.
The Commerce Department recently reported that the U.S. economy (i.e., gross domestic product) shrank at an annual rate of 2.9% in the first quarter. The consensus is that the brutal winter put a chill on the economic recovery and long-awaited growth didn’t materialize in the first quarter. When we consider the annualized performance of the S&P 500 in the first quarter, the results generally pale in comparison to full-year 2013 results, as shown in Figure 1.
Figure 1. S&P 500 median financial performance, 2014 first quarter versus 2013
There are, however, some glimmers of hope. Job growth has picked up, and first-quarter 2014 financial results compare more favorably to the first quarter of 2013 than to the year as a whole (see Figure 2). The bottom line is that increasingly robust performance expectations have been built into stock prices, with the results reflected in rising valuations. For example, the median S&P 500 price/earnings ratio has risen from 16 in 2012 to 20 in 2013 and to 21 in the first quarter of 2014.
Figure 2. S&P 500 median financial performance, 2014 first quarter versus 2013 first quarter
When we consider stock returns, we see that the S&P 500 is well below last year’s trajectory, as shown in Figure 3. The lofty valuation ratios suggest that strong returns throughout the remainder of the year will require improved financial performance, not just higher valuation ratios.
Figure 3. Monthly median total shareholder return for the S&P 500
The key takeaway is that performance expectations remain heady, as is evident in the rising valuation ratios. This underscores the importance for companies to ensure that their pay programs align earned compensation with performance results.
Second-quarter results will be available in coming weeks, providing a better read on the economic trajectory. Will the economic recovery kick into high gear or hit another soft spot? The answer will have significant implications for rewarding and engaging executive talent. Stay tuned for updates.
Steve Kline, CFA, is a director in Towers Watson’s Pittsburgh office who leads the firm’s executive compensation consulting practice in the east central United States. Chris Kozlowski is an executive compensation analyst in Pittsburgh. Ryan Lucki is an executive compensation consultant in Pittsburgh. Email firstname.lastname@example.org, email@example.com, firstname.lastname@example.org or email@example.com.