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Worse than random 

16 April 2014 By Edward Hadas

Coca-Cola’s plan to give generous awards of shares to executives has angered some of its shareholders. They have good reason to complain about the potential transfer of about 15 percent of the company to the top 1 percent of its staff. But Coke is only pushing the already bad idea of share-based pay to a foolish extreme.

The justification for paying workers in their employer’s paper is simple and superficially appealing. Worker-owners might be more motivated to push for higher profit than if they just received salaries, even salaries which have bonuses in the millions tied to company performance.

The argument relies on a narrow view of corporate purpose: the sole goal is to maximise the share price, that is, the present value of future profit. Even if that doubtful assertion is accepted, the connection between an individual worker’s contribution and the movement of the share price is too weak for stock awards to motivate behaviour.

In fact, it’s worse than that. Changes in the share price have little to do with actual improvement or setbacks to corporate prospects at all. Financial theory says otherwise. It relies on a claim that the current share price is always the best available estimate of value. The messy reality is different. Economics Nobel laureate Robert Shiller identified one problem in 1999, saying “prices change in substantial measure because the investing public en masse capriciously changes its mind.” The subsequent gyrations of stock markets have demonstrated that financial conditions also have a great influence on share prices.

Over the decades, all investors’ psychological errors might be corrected and all monetary forces could cancel each other out. But shareholding workers may well have to wait a half-century or so before they can be confident that the stock market will justly reward them for their company’s economic performance. Most of the employees concerned will have retired or died by the time the stock and economic returns have been well aligned. In the interim, the price will reflect many things, with corporate success quite a way down the list.

The responsibility of almost all workers is too limited to move the share price. A few top executives have that power, but even they are often victims or beneficiaries of larger trends. They must deal with an existing enterprise, respond to changes in technology and taste, and ride economic waves. Those factors, plus luck, almost always have far more influence on share movements than individual genius or foolishness.

In the circumstances, share awards seem at best irrelevant. But this form of pay is actually harmful. It makes employees more dependent on their employer’s fortunes, both in the stock market and in the real world. That is bad personal finance for junior employees. It can lead higher-level employees to favour unduly whatever foolishness investors currently demand.  In addition, rising share prices can lead to overconfidence and falls can hurt morale.

As for the many outside shareholders who favour share awards, they are endorsing a technique of wealth subtraction for themselves. Any shares issued at a discount to the market price reduce the economic value attributed to each previously issued share.

Defenders of share awards often deny there is a loss of value to existing shareholders, as long as stock buybacks are used to keep the total share count constant. Reported earnings per share support this defence, but only because the accounting for buybacks is economically inaccurate. If the share repurchases were treated correctly – which are generally a kind of dividend distribution with no real effect on the equity capital base – it would be clear that they do not actually compensate for the new shares issued to employees.

Still, there is one thing to be said in favour of making employees shareholders: it blurs the socially divisive distinction between capital and labour. Unfortunately, the effect is muted by the narrow group of workers who receive stock awards – just look at Coke.

If managers really wanted to use stock awards in a fair way, they would start by buying the shares they want to give employees in the open market. Then they would award equal numbers of shares to each employee. Ideally, the shares should be held in trust until retirement or later, to minimise any temptation to worry about the share price.

It’s a nice plan, but something tells me that few top executives are going to be interested.

 

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