Alan Reynolds

Every year about this time, the nation's leading newspapers and business magazines begin to compete to see who can appear most outraged about how much the top corporate CEOs were paid during the previous year. Thus on June 25, 2001, Fortune featured "The Great Pay Heist," complaining about the "highway robbery" of the year before. We are sure to be deluged by similar stories in the next few weeks. This is an annual sport.

 These annual reports on CEO pay need to be read more carefully than they are written. It helps to begin with a few tips for the unwary learned from previous years:

 Lesson One: Nearly every major newspaper and business magazine has its own uniquely dubious way of handling the way stock options are valued as executive pay.

 On March 25, 2002, Gary Strauss of USA Today wrote that top executives "rarely felt shareholders' financial pain last year." On April 15, by contrast, Business Week reported that CEO pay fell by "nearly 31 percent, to ... a level not seen since 1997." 

 These two completely contradictory conclusions illustrate just two contradictory ways of measuring CEO pay. There are more. Business Week included the value of older options that had been cashed-in (exercised) that year. Fortune instead chose to crudely estimate the value of new options as one-third of their face value. Not to be outdone, USA Today added both. They counted both the cost of options exercised in 2001 and the estimated value of options granted in 2001. That meant an executive's pay in 2001 could include compensation for work done in any or all years between 1991 and 2005.

 Lesson Two: Although estimates of the "fair value" of new stock options are commonly lumped together with cash salaries and bonuses, such estimates tell us next to nothing about how much cash executives will receive. To estimate the value of options when granted, Fortune has simply assumed the options were worth a third of their face value. Even with sophisticated estimates, however, risky options cannot sensibly be treated as if they were no different from an equivalent salary or bonus. A Washington Post story fussed over AOL stock options granted to Steve Case in 2001, said to be worth $76 million. But that estimate depended on AOL stock being worth $49 to $73 a share by now. The estimate (the same sort that FASB wants firms to "expense") was pure smoke.

 Lesson Three: Selling off assets is no different than selling a home -- it does not make an executive wealthier, and it should not be counted as income.

Alan Reynolds

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