3 ways to tell if CEOs and directors are overpaid

As a shareholder of any company, I truly believe that key management should be fairly rewarded and well compensated when they perform well in their roles. But I have an issue if they reward themselves excessively – especially if they underperform in their roles and the company is doing badly. This is a red flag that tells the management is not aligned with shareholders’ interests and they care more about their fancy pay packages regardless of how the company is performing.

If you ever need to check how much a company’s CEO and directors are paid, you can always check the company’s annual report. Most regulators in their respective exchanges require directors’ remuneration to be disclosed publicly.

How does a company decide how much to pay its key management?

To be as impartial as possible, a remuneration committee, made up of independent directors, approve the remuneration packages (remuneration is not limited to salary; it also includes bonuses, stock options, and deferred compensation). However, these independent directors are being paid by the company as well.

An old adage: “Whose bread I eat, his song I sing” reminds us that this practice doesn’t fully protect shareholders’ interests. It is much better for you to do your own research and decide if the company’s directors are paying themselves too much.

From my experience, there are three telltale signs that management is abusing shareholder trust and awarding themselves underserved and excessive remuneration packages:

1. The business is losing money yet they continue to overpay themselves

I met with a seasoned investor recently who used to run a successful business which he and his partners later sold for over $300 million. He shared a story of taking a 50% personal pay cut when his company hit particularly difficult times. His senior management took a 20%-30% pay cut as well. But he refused to cut the salaries of his staff.

His reasons were clear: Top and senior management can afford to take a temporary pay cut and still have enough to sustain their lifestyles. However, for someone who makes $3,000/month, even a small pay cut will have drastic effects. He said, “Every single dollar is important to them because they have a family to feed and we can’t reduce their pay just like that.”

So when analyzing the management behavior of a company, ask yourself if top management takes a pay cut when times are bad. We all prefer a CEO who generates $10 million in profits for his company and pays himself a million rather than a CEO whose company is losing money but still pays himself a million just because that’s the market salary for a CEO.

If you ever spot management paying themselves lucratively when their business is losing money, you might want to consider parking your investment elsewhere.

2. Excessive stock options granted

Salaries and bonuses are not the only way CEOs and directors are paid. They can be awarded stock options as well as a form of remuneration. Stock options or restricted stocks are a great way to remunerate people as those who are awarded them view themselves as having ownership in the business. Because of this, they are more likely to work harder and generate more profit for the company. Ultimately, more profit usually translates into higher stock prices and the stock option holder is rewarded.

However if management is awarding themselves excessive amounts of stock options compared to the results and the performance of the company, it is something you need to sit up and take notice of. When these stock options are exercised, new shares are issued and dilutes the value of outstanding shares.

When analyzing, take a look at the number of stock options as a percentage of the number of outstanding shares. You’d much prefer a company that has small percentage versus a company that has issued stock options worth 10% of outstanding shares.

3. Being paid through subsidiaries

There was once I spotted a potential turnaround company listed in Singapore that I thought was a great investment opportunity. Upon further research, I noticed that the chairman was being paid a salary through the holding company as well as two of its subsidiaries as well.

In my opinion, I felt the chairman had no need to be paid two additional salaries through his subsidiaries as he was already paid a significant one by his parent company and a major shareholder in all three companies. You could argue that he deserved his multiple salaries if his company was performing well, but its market capitalization has declined from $1 billion to less than $130 million today.

Needless to say, it put me off investing because I couldn’t trust the company’s key management to be aligned with shareholders’ interests and lead the company to its former heights.

The key lesson here is this: any behavior that shows that management is more interested in being rewarded handsomely regardless is a telltale sign that they put their self-interests over their shareholders’ (by squeezing every single penny out at the shareholders’ expense). Avoid them at all costs!