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Evaluating A Company's Management

2012-01-03 12:46:05

Most investors realize that it's important for a company to have a good

management team. The problem is that evaluating management is difficult - so

many aspects of the job are intangible. It's clear that investors can't always

be sure of a company by only poring over financial statements. Fallouts such as

Enron, Worldcom and Imclone have demonstrated the importance of emphasizing the

qualitative aspects of a company. There is no magic formula for evaluating

management, but there are factors to which you should pay attention. In this

article we'll discuss some of these signs.

Tutorial: Behavioral Finance

The Job of Management

A strong management is the backbone of any successful company. This is not to

say that employees are not also important, but it is management that ultimately

makes the strategic decisions. You can think of management as the captain of a

ship. While not physically driving the boat, he or she directs others to look

after all the factors that ensure a safe trip. (For further reading, see

Lifting The Lid On CEO Compensation.)

Theoretically, the management of a publicly traded company is in charge of

creating value for shareholders. Management is to have the business smarts to

run a company in the interest of the owners. Of course, it is unrealistic to

believe that management only thinks about the shareholders. Managers are people

too and are, like anybody else, looking for personal gain. Problems arise when

the interests of the managers are different from the interests of the

shareholders. The theory behind the tendency for this to occur is called agency

theory. It says that conflict will occur unless the compensation of management

is tied together somehow with the interests of shareholders. Don't be naive by

thinking that the board of directors will always come to the shareholders'

rescue. Management must have some actual reason to be beneficial to

shareholders.

Stock Price Isn't Always a Reflection of Good Management

Some say that qualitative factors are pointless because the true value of

management will be reflected in the bottom line and the stock price. There is

some truth to this over the long run, but strong performance in the short run

doesn't guarantee good management. The best example is the downfall of dotcoms.

For a period of time, everybody was talking about how the new entrepreneurs

were going to change the rules of business. The stock price was deemed as a

sure indication of success. The market, however, behaves strangely in the short

term. Strong stock performance alone doesn't mean you can assume the management

is of high quality.

Length of Tenure

One good indicator is how long the CEO and top management has been serving the

company. A great example is General Electric whose former CEO, Jack Welch, was

with the company for around 20 years before he retired. Many herald him as

being one of the best managers of all time.

Warren Buffett has also talked about Berkshire Hathaway's superb record of

management retention. One of Buffett's investment criteria is to look for solid

stable managements that stick with their companies for the long term. (Learn

more in Management Strategies From A Top CEO.)

Strategy and Goals

Ask yourself, what kind of goals has the management set out for the company?

Does the company have a mission statement? How concise is the mission

statement? A good mission statement creates goals for management, employees,

stockholders and even partners. It's a bad sign when companies lace their

mission statement with the latest buzz words and corporate jargon.

Insider Buying and Stock Buybacks

If insiders are buying shares in their own companies, it's usually because they

know something that normal investors do not. Insiders buying stock regularly

show investors that managers are willing to put their money where their mouths

are. The key here is to pay attention to how long the management holds shares.

Flipping shares to make a quick buck is one thing; investing for the long term

is another.

The same can be said for share buybacks. If you ask management of a company

about buybacks, it will likely tell you that a buyback is the logical use of a

company's resources. After all, the goal of a firm's management is to maximize

return for shareholders. A buyback increases shareholder value if the company

is truly undervalued.

Compensation

High-level executives pull in six or seven figures per year, and rightly so.

Good management pays for itself time and time again by increasing shareholder

value. But knowing what level of compensation is too high is a difficult thing

to determine.

One thing to consider is that managements in different industries take in

different amounts. For example, CEOs in the banking industry take in more than

$20 million per year, whereas a CEO of a retail or food service company may

only make $1 million. As a general rule you want to make sure that CEOs in the

same industries have similar compensation. (Learn more in Whom Should

Corporations Please?)

You have to be suspicious if a manager makes an obscene amount of money while

the company suffers. If a manager really cares about the shareholders in the

long term, would this manager be paying him/herself exorbitant amounts of money

during tough times? It all comes down to the agency problem. If a CEO is making

millions of dollars when the company is going bankrupt, what incentive does he

or she have to do a good job?

You can't talk about compensation without mentioning stock options. A few years

back, many praised options as the solution to ensuring that management

increases shareholder value. The theory sounds good, but doesn't work as well

in reality. It's true that options tie compensation to performance, but not

necessarily for the benefit of long-term investors. Many executives simply did

whatever it took to drive up the share price so they could vest their options

to make a quick buck. Investors then realized the books had been cooked, so

share prices plummeted back down while management made out with millions. Also,

stock options aren't free, so the money has to come from somewhere, usually the

dilution of existing shareholder's stock.

As with stock ownership, look to see whether management is using options as a

way to get rich or if it is actually tied to increasing value over the long

run. You can sometimes find this in the notes to the financial statements. (For

more on this, see Footnotes: Start Reading The Fine Print.)

If not, take a look in the EDGAR database for a Form 14A. The 14A will list

among other factors background information on the managers, their compensation

(including options grants) and inside ownership.

The Bottom Line

There is no single template for evaluating a company's management, but we hope

the issues we've discussed in this article will give you some ideas for

analyzing a company.

Looking at the financial results each quarter is important, but it doesn't tell

the whole story. Spend a little time investigating the people who fill those

financial statements with numbers.

by Investopedia Staff