Rank-based Benchmarking a Recipe for Mistakes

In a volatile market, movements in share price can make a mockery of targeted benchmarking based solely on ASX or NZX rank.

Consider the following S&P CapitalIQ graphs that chart movements in company share price against the S&P/ASX 200 over 5 years.

Fortescue Metals – Dropped from ranking in the top 20 companies, to only just staying in the top 50, then rose back up to the top 20 again

Fortescue share price

Qantas – moved in and out of the top 50
Qantas share price movement

Slater and Gordon – Ranked at the bottom of the top 300, then moved to just graze the top 100 before falling outside the top 500.
Slater and Gordon share price movement

Sirtex – Shifted from the bottom of the top 300 to rising and falling in rank within the second 100
Sirtex share price movement

These movements in rank will make a significant difference to remuneration benchmarking if that benchmarking is conducted based solely on market capitalisation rank, and no other financial metrics or company attributes are taken into account.

To illustrate, consider a hypothetical company that ranks around 80. Let us imagine that this company was in the mining industry and experienced a rise in the price of the commodity it was mining. As a result, the share price rises significantly and the rank of the company moves to be 40. Then let us imagine there is a mining disaster that involves multiple fatalities likely to lead to international lawsuits. The company’s share price falls and it is ranked 120.

Let us assume that these movements occur in a relatively short time frame and the fundamentals of the company do not change significantly. Revenues are $1.3 billion. Operating profit is $200 million and Total Assets change to $3 billion.

If benchmarking this company based purely on rank using a narrow band of companies, the fixed remuneration and bonus for a top 5 executive would look like this:

Table 1 – Benchmarking based on rank only

Benchmarking using rank

As a company moves up or down in rank, the difference in remuneration is significant. Yet such movements may be due to market sentiment or circumstances that are outside of the control of the executive. Should they be rewarded or penalised in terms of remuneration for such movements? Has the company changed so significantly that their role deserves more or less remuneration?

Clearly, any decision to benchmark remuneration based solely on a volatile measurement such as market capitalisation is risky. It is best to consider a number of metrics.

If we also include any companies with similar revenues, operating profit and total assets, the benchmarking result looks like this:

Table 2 – Benchmarking based on Rank, Revenues, Operating profit and Total Assets

Benchmarking on rank and other metrics

As can be seen, if the sample is expanded to include companies of similar fundamentals, the differential caused by the company moving up or down in rank is reduced.

If the new sample contained too many companies whose attributes were very different to the organisation being examined, the decision might be made to tighten benchmarks to include any company where at least two metrics were similar. The results are below:

Table 3 – Benchmarking based on Rank, Revenues, Operating Profit and Total Assets where each company included in the sample must match at least two metrics

Benchmarking on rank and other metrics with two metrics matching

Another method of ensuring companies are similar is to examine only companies within the company’s sector or industry.

This is not advisable if only benchmarking on rank using a tight band, as there are only a handful of companies in the desired sector within each band, making sample size too small. However, we can narrow our samples used for Tables 2 and 3.

Table 4 –  Benchmarking based on Rank, Revenues, Operating Profit and Total Assets where each company included in the sample must be part of the Materials sector

Benchmarking on an industry

 Table 5 –  Benchmarking based on Rank, Revenues, Operating Profit and Total Assets where each company included in the sample must match at least two metrics and be part of the Materials sector

Industry specific benchmarking with two metrics

Considering these results, it is possible to gain an idea of the range of remuneration paid for roles within companies similar to the company being examined. To ascertain where a particular employee’s remuneration should lie within the range, the role’s scope and accountabilities and the individual’s performance will be considered, along with the company’s remuneration policy and the importance of the role to the company’s strategy and sustainability.

When conducting a remuneration review, it is very difficult to reach an informed decision if the initial range is derived from limited data. As illustrated above, the chance of the range being too high or too low is much more significant when only one metric – rank – is utilised to conduct a market comparison.

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