Cost vs Value: companies and their managers
Cost and value are two different things.
Such a simple statement, but it hides an essential truth which is so often ignored when we look at company performance and weigh up management talent.
Cost is what you paid to get something, make something, or hire someone. It is tangible, comes with receipts, Board minutes and so forth. Value, on the other hand, is what some thing, some event, is worth to us. How much utility or benefit did we derive from the products, services, ‘events’, people that we paid for? There is a right answer for costs. There is no right answer for value. Value is subjective and varies depending upon things like ‘the experience’, the ‘potential upside’, our preferences, needs and expectations. It varies from person to person.
A quick example will suffice. A cup of coffee, brewed and served at home, costs (according to many reliable sources) around 15p per cup. A caramel frappacino (as of mid-May 2023) at Starbucks is £4.28 and a Jamaican Blue Mountain coffee from Wallenford Estate served at Queens of Mayfair will cost around £15. Why the difference? The answer is the value we place on the experience: the quality, the taste, the reputation, the company, the memory, the reliability and so forth.
Cost v value is such an important distinction because herein lies the confusion at the heart of government, shareholder and regulatory thinking about executive pay, and the underlying performance that justifies it.
If we take companies first. There are many companies you may have heard of which are actually selling products that cost far less than the revenues generated. For example, Apple Inc. (Mkt Cap $2.7 trillion, EBITDA $124billion) has margins of around 43% on its products. In other words, the products and services cost, including marketing, R & D, operations, etc is around half what Apple sells them for. Louis Vuitton (Mkt Cap $443billion, EBITDA $17 billion) has margins of 68% on their fashion products ie. they cost less than a third of the amount they are sold for.
These companies are not fly-by-night operations. They are long-standing, highly regarded companies delivering something we ‘value’ highly. Perhaps the most obvious example is of De Beers diamonds. The mark-up on diamonds is roughly three times their actual cost, and that is because someone, somewhere wants to send a message to their loved one, and being cheap about it isn’t the best idea.
Not only are product costs and product values at odds, sometimes, but the companies themselves are also subject to the same rules on cost v value. Does it surprise any reader that the following companies exhibit a (market) price (to) earnings multiple which is up to 30 times the norm for stock valuations in relation to EBITDA currently:
- Zoom (Video comms)
You only have to pick up a recently delivered Amazon parcel which was paid for with PayPal, watch Netflix (or Amazon Prime), conduct yet another Zoom video call from home or leave home in your Tesla (consider this in the context of the UK Government’s mandate to prohibit combustion engines by 2030) to know why we ‘rate’ these companies.
Rating is, in fact, the code name for gearing up cost to value. The higher the rating the more the ‘market’ (that odd collection of soothsayers we call investors) deems a company to have a high growth future. Earnings may be good today, but it will be great tomorrow, they say. It is non-scientific but reflects the brilliance of the brains behind strategies that transformed our lives.
Is that worth paying for? You bet. The problem is that when faced with the stark reality of a large executive pay-out, investors suddenly think about the cost of talent, not its value. That is a pity, because we can end up under-paying for rare talents which truly make a difference, and (more often than not) over-pay for those who are ‘CEO care-takers’. No CEO would want to be referred to in that way, but if they are not inventing the future, what are they doing?
Our way of thinking about this is the CEO Value Index - a simple ‘rule-of-thumb’ which shows how much the investors in a company gain for every £1 or 1$ paid to a CEO. The total Value Added over 4 years, divided by the CEO’s Total Remuneration over the same period
- We look at Value Added to shareholders by the company over a four-year period and include changes in market capitalisation, dividend payments and share buybacks
- We then look at Total Remuneration paid to the CEO over the same time frame – we look at all salary paid, all bonuses actually paid, and the realised value of long-term incentives during that period
Our data library has been accumulating since 2012.
The consistency of the Index findings is remarkable, with the range of CEO Value Index outcomes remaining within a very consistent range for over ten years.
We can say, for example, that – despite his remarkable ‘cost’ [$36m in 2022], the value added by the CEO of Exxon was £5,271 for every £1 paid to all of their shareholders. A typical FTSE100 CEO barely reaches £500, the top ten Index performers in the FTSE100 ranged from £550 to £4250 last year.
In other words, he may be cost a lot, but he is value to Exxon investors.
Would it not make more sense to report executive pay in terms of value, not just cost? The analysis can be conducted for any firm, anywhere in the world, at any time – they can all be compared with our database.
For shareholders: a clear and immediate evidence of whether their executives are delivering value, relative to the total pay opportunity being offered
For remuneration committees: and reward professionals the ability to review the results of incentive compensation design. How well did pay align with performance? How does our pay to performance alignment compare with other relevant comparators?
For regulators and commentators: a comprehensive view of pay and performance across the UK, over time and across sectors
A snapshot of pay-to-performance alignment, providing an objective ‘commentary’ on recent regulatory changes
The index is a clear and simple concept, one that should arguably be in the kit bag of any remuneration committee chair - another useful reference point as part of a more nuanced debate on executive pay. It’s too simplistic to look at the single figure in isolation – thriving companies create jobs, pay tax, sustain supply chains. Some CEOs are genuinely gifted and have changed the way we live forever. It would be a shame if the price paid for the value they create acts more like a stick, or a disincentive to do what they do best.
It’s easy to be a cynic, given the huge numbers that are often involved, but Oscar Wilde described a cynic as someone who knows the price of everything and the value of nothing. How right he was. Hopefully, as the debate plays out in public in the coming months (the CEO of the London Stock Exchange recently called for “constructive discussion” on executive remuneration), it can be a balanced, grown-up debate, one that not only educates us but also recognises that value created extends far beyond the ‘C-Suite’ at the top of the organisation. A gifted CEO can transform a company’s fortunes, but they rarely do it alone.
 Earnings Before Interest Depreciation Amortisation
 S&P 500 P/E Ratio is at a current level of 22.23, up from 19.17 last quarter and down from 24.09 one year ago. The current trailing P/E of the FTSE100 is 13.88 (12/31/2022) and the cyclically adjusted (CAPE) ratio is 19.28
 As of mid-May: Tesla (Earnings:Price multiple 51); Amazon (Earnings:Price multiple 262); Netflix (Earnings:Price multiple 36); Zoom (Earnings:Price multiple 192); Paypal (Earnings:Price multiple 30)