Why Total Rewards Leaders Should Pay Attention to Non-Financial Data
Conventional thinking from years past might have suggested that financial statements affect the stock price and the proxy or corporate social responsibility (CSR) report are mere side projects. Under this view, total rewards leaders impact company value through their initiatives to attract, motivate, and retain talent, but not any external reporting they oversee. That’s been changing, and we’ve probably only scratched the surface.
A growing number of investors are considering HR’s disclosed information when making buy, sell, and ballot decisions. In fact, we think we’re in the midst of a transformation where a host of non-financial statement data in the proxy, CSR report, and 10-K human capital management (HCM) disclosure will impact equity valuations. There is growing scrutiny of the information companies publish across their environmental, social, and governance (ESG) practices. Although environmental matters have occupied the spotlight as of late, we’ll be focusing on the “S” and “G” and their comparable importance.
This is our first of many articles focused on the role of non-financial proxy, CSR, and HCM reporting in equity valuation. We’ll cover some basics on equity valuation, why (and how) non-financial data can move security prices, and what this means for the total rewards team responsible for sourcing this data.
Equity Values and the US Capital Markets
Before diving in, let’s talk about the nature of this sea change in equity valuation.
The traditional business school training regimen focuses on how data in the financial statements—meaning the income statement, balance sheet, statement of cash flows, and statement of stockholders’ equity—drives equity values. Market participants use the data to evaluate stocks by crunching financial statement ratios and building cash flow models. This exercise, commonly referred to as fundamental analysis, is a key factor keeping the capital markets efficient. As the theory would have it, equities are generally priced “right” because so many people are performing rigorous financial analysis in search of an opportunity to make an abnormal return that the odds of actually finding one become quite small.
In this view, the US capital markets are the most efficient in the world in part because financial statements are rigorously audited and provide reliable information about a company’s financial performance.
It’s worth noting that a more nuanced or advanced view recognizes that many factors keep markets efficient. A strong regulatory environment is certainly a factor. Creative and resourceful stock analysts are another. For example, some hedge funds will study satellite imagery of company parking lots to gauge a company’s demand momentum.
What’s Changing (And Why)?
However, classic fundamental analysis is becoming less relevant to equity valuation. Columbia Business School’s Shiva Rajgopal has described a number of factors behind this trend. One is a lack of interest among passive investors, whose analysis focus is elsewhere. Passive investors often own the lion’s share of a company’s outstanding shares.
To understand their influence, consider that pensions and other passive investor funds have charters that preclude them from actively entering and exiting stocks. This means they must look beyond financial statement performance for information to help them manage risks and opportunities. In the proxy and CSR report, passive investors can find information that speaks to the effectiveness of director oversight and progress in managing long-run systemic risk areas.
At the same time, interest in ESG considerations is on the rise more generally. A cottage industry of rating agencies and frameworks has emerged to enable ESG scoring. You don’t need to travel any further than the Sustainability tab on Yahoo! Finance to peruse company ESG scores. With an ever-expanding rating infrastructure, investment firms have been busy constructing ESG-aligned fund options for a deeply interested investing public. In turn, companies compete to get scooped up into these ESG-themed funds.
That’s not to say financials no longer matter. The market turbulence of late 2022 and 2023 has brought fundamentals like profitability and cash flow back into focus. The reality is that financials never lost their importance. They just now compete with a slate of other, non-financial, variables.
Scope of Non-Financial Data
So what are the non-financial variables that the compensation function produces? Let’s walk through some examples that appear in the proxy, 10-K HCM disclosure, and CSR report. There are other platforms for disclosing human capital data (e.g., company websites), but we’ll focus on these three outlets.
1. Executive Compensation Data
The proxy has changed significantly in recent years. It used to be a document mainly for soliciting shareholder votes on director reelections and auditor nominations, both of which were typically foregone conclusions. Now it’s much more quantitative, offering cuts of executive pay data and complex financial modeling. Different tables, from the Summary Compensation Table (Item 402(c)) to the newly introduced pay vs. performance disclosure (Item 402(v)), must all hang together.
The volume of analytics and data running through the proxy is astounding. If you study proxies closely, you’ll notice there are frequently errors and revisions to prior year tables. This reflects another reality: The proxy isn’t audited. In fact, the running joke is that the external auditors focus on one figure in the proxy, which is that their audit fees are correctly presented.
2. Pay Equity Data (Adjusted and Unadjusted)
A number of institutional shareholders want to see pay equity disclosures. Some investors focus more on the unadjusted gap, whereas others prefer the US-based norm of adjusted gaps. In any event, external disclosure is a sensitive decision that many aren’t yet ready to make, but the pressure is clearly intensifying.
Companies calculate unadjusted and adjusted pay gaps, the latter coming from a regression-based pay equity study. Most experts agree that adjusted pay equity statistics are the most meaningful reflections of the fairness and effective operation of a company’s pay programs. These analyses are usually performed under legal privilege and involve advanced econometric model building. However, there are no universal standards governing their preparation, making comparability a pipe dream at this juncture.
3. Representation Progress
A growing number of companies are disclosing representation levels, both broadly and within their executive ranks. Gender breakdowns can be disclosed globally whereas ethnicity/race analytics are still primarily disclosed on a US-only basis. These disclosures appear in the 10-K HCM section and the CSR report.
Some companies disclose only a current snapshot. Others provide future goals and progress reports against those goals. Naturally, investors are pushing for long-term goals and frequent updates so they can assess whether a company’s initiatives are working.
4. Spring-Loading (Equity Award Timing)
In November 2021, the SEC released Staff Accounting Bulletin No. 120. Among other things, it requires that any equity grants deemed to be spring-loaded should be valued accordingly. A spring-loaded grant is one that’s issued on the eve of positive material non-public information (MNPI) disclosure such that the MNPI causes the stock to spike shortly thereafter. A bullet-dodging grant is the inverse, in which a grant is delayed until after MNPI is released.
More recently, in December 2022, the SEC issued its final 10b5-1 rules. The rules require both a narrative disclosure on equity grant timing and a new table in the proxy that’s triggered by any grant occurring either four days before the release of MNPI or one day after.
The SEC introduced these rules in response to investor concern that insider information is being used opportunistically. Already, we’ve seen a handful of companies come close to triggering one of these watermarks—not due to opportunistic behavior, but simply different organizational silos managing different issues on different timelines.
5. Storytelling in the Proxy
Although the proxy has become a deeply quantitative document, the messaging in the compensation and discussion analysis (CD&A) is equally important. The CD&A is supposed to explain to an outside party the compensation committee’s thought process in arriving at their decisions.
The CD&A follows a generally consistent format but the information it shares can vary. Non-financial data may include a discussion of shareholder outreach efforts, plan design refinements, a framework for evaluating pay vs. performance (e.g., realizable pay disclosure), how individual executive performance is assessed, and much more. A particularly popular issue at the moment is whether to include ESG metrics in either the short-term or long-term incentive plan. Investors aren’t necessarily clamoring for this, but they are asking why and why not.
This list isn’t exhaustive. Keep in mind that investors rely on numerous other types of non-financial data, such as environmental disclosures. We don’t discuss the proposed climate standard here, but it will likely prove a game-changer for external reporting.
Non-Financial Data Can Move Security Prices
If compensation leaders are producing and disclosing non-financial data, the next question is whether any of these data points can impact security prices.
At a minimum, non-financial data in the proxy will influence the (non-binding) say-on-pay vote. Companies expend a lot of effort to achieve say-on-pay results above 90% because results below that level are generally considered negative.
But our sense is that this is just the tip of the iceberg. As more investors extend their scrutiny beyond the financial realm, they’ll likely demand more varied types of non-financial data. Let’s discuss the pathways through which these can move stock prices up or down.
1. Director Elections
We’ve discussed how the SEC’s universal proxy ballot makes it easier for activists to pluck off individual directors. This is consequential because director contests have repercussions on security prices. Sometimes the effects are favorable, other times the opposite.
Director contests can be triggered by strategic concerns, financial underperformance, corporate governance lapses, or any number of factors. But they have two consistent qualities. One, the battleground is the proxy. Two, executive incentives and human capital invariably get folded into assertions that one or more directors are ill-suited for the role.
One recent case was Zevra Therapeutics. Zevra maintains a staggered board. All three directors up for reelection this year lost by a landslide and were replaced by three candidates that activist investor Daniel Mangless had put forward. The primary trigger for contesting the incumbent directors was poor stock price performance, but the activist’s arguments hinged on information from the proxy such as excess executive pay and low director stock ownership.
The day after the director election results were reported, Zevra’s stock fell 7%. Other directors resigned along with the CEO and by May 12, the stock price had fallen a cumulative 24%. More recently, a positive earnings release led to a partial rebound.
Illumina is another recent case. On May 25, Carl Icahn successfully replaced one director after a heated battle. Illumina’s stock price fell 9%. It’s unclear whether the market was hoping that all three alternate directors would be installed (i.e., one wasn’t enough) or that even one installation could lead to costly gridlock and paralysis.
In any event, director elections matter and the proxy is the principal battleground on which they take place.
2. Stock Selection
ESG ratings are primarily based on self-disclosed information in the CSR report and other company materials. With the growth in ESG-based funds, the demand for a stock can quite literally depend on the non-financial data in the proxy and CSR report used to inform an ESG rating.
The logic adopted by these funds is that companies with higher ESG scores are better positioned to manage emerging risks, adapt to changing regulations, and capture business opportunities from environmental and social trends. As the logic went, stocks with strong ESG scores would be favored by investors seeking to align their investments with certain values and mitigate what they consider to be long-run existential risks to an industry or group of companies within an industry.
It’s worth distinguishing between two flavors of research on the topic. One looks at whether firms with sustainable business practices outperform their pure play peers without such practices. The second, and our focus here, points out the mechanical relationship between ESG scoring, stock selection by ESG-themed funds, and therefore equity valuation. If ESG-themed funds pick stocks based on how many ESG “points” a company accumulates, then the exercise of accumulating such points via external disclosure can have a very real effect on the stock price and valuation.
Our focus in this article has been the S and G of ESG, which are the areas compensation leaders touch most directly. However, research shows that all three factors are value-relevant to investors and tend to vary based on industry. This is consistent with the notion that ESG in its best and most relevant form is intimately linked to business strategy.
3. Activism Defense
Activists come in all shapes and sizes. Some have oriented their business models around ESG whereas others are more traditional corporate “restructurers” who will prioritize an ESG issue when convenient. Recent experience has shown that a small activist who builds a case around an ESG issue of broader concern can capture support from larger passive investment firms who also care about that issue.
Although not related to any sort of human capital matter, Engine 1 successfully captured three board seats at Exxon Mobil in 2021 by using climate concerns as a lightning rod to garner support from the large institutional investors also casting proxy votes.
A powerful discussion of the confluence between activism, institutional investor followership, and non-financial priorities is provided in this HBR article by Robert Eccles, a famous academic and prolific author on non-financial topics.
4. Public and Employee Perception
A recent McKinsey study showed that consumers are paying more attention to ESG-related disclosure when making purchasing decisions. Obviously, the primary way of communicating with a consumer isn’t the proxy, but companies will look to be consistent across their consumer messaging platforms and their investor reporting.
In our direct consulting experience on pay equity, we consistently see how employees are deeply interested in knowing as much as they can about what their employers are doing to assess and preserve pay equity. Both the signaling that comes from maintaining a robust pay equity program and the substantive outcomes are integral to attracting and retaining talent.
While these factors present the most indirect effects on security prices by affecting operations, they’re just as real as the more direct finance-linked effects discussed above. After all, this is why investors care in such profound ways about the non-financial data that the total rewards function reports.
Risks and Considerations for Total Rewards Leaders
Although the non-financial data reported on by the total rewards function has always mattered, it now matters in new ways because this information has a much stronger tie-in to investment decisions.
SEC Rule-Making and Litigation
With the tsunami of new demand for non-financial data comes the risk of abuse and misuse. This has occurred in two forms. On the corporate side, some companies have been accused of dressing up and inflating their ESG disclosures. On the investment adviser side, some managers have been accused of falsely marketing the ESG alignment of their investment funds. These activities, commonly referred to as greenwashing, have been met by swift SEC scrutiny. Two proposed rules are slated to be finalized shortly, one on the naming of investment funds and one on disclosure.
In addition to SEC rule-making, which is preemptive, there’s SEC enforcement, which is responsive. In April 2022, the SEC brought its first ESG-linked action against a mining company, arguing that the company misled and harmed investors by making misleading claims about the safety of its dams. This was a securities fraud case taking a roughly similar form as the traditional cases targeting fraudulent financial reporting.
Another recent case involved the video game company Activision Blizzard. Activision settled a case with the SEC over the company’s lack of controls and procedures to track workplace complaints even though Activision management represented to their board and shareholders that there were no such issues. The substance of the complaint was that it was misleading to make certain representations about culture and workplace conduct when there simply wasn’t a vehicle to track and assess those very issues.
With the growing volume of non-financial data formally reported in the proxy, 10-K HCM disclosures, and the CSR report—not to mention proxy and 10-K contents being filed and not merely furnished—the risk is growing that a shareholder will argue they made an investment decision based on a misleading or incorrect disclosure. For these claims to prevail, the plaintiff must prove the loss in value stemmed from the erroneous disclosure. But as the causal link between ESG information and asset pricing tightens, this outcome becomes increasingly plausible.
A more immediate risk is that the shareholder lawsuit focuses on the directors and officers shirking their oversight duties to properly monitor and track organizationally critical data. In the wake of the Court of Chancery of the State of Delaware extending the Caremark framework to corporate officers, these sorts of lawsuits also become more realistic.
Cost of Equity and Valuation
To value equities, analysts develop future cash flow models based on projections and then discount those cash flows back to the present. One of the most important assumptions in any such model is the discount rate, also referred to as the cost of equity.
Academic research has found that CSR information that’s audited (and thus deemed more reliable) is associated with lower discount rates and therefore higher valuations. Whether the SEC should mandate that CSR reports or proxies be audited is too big of a question to tackle here. What we can say is that investors view these data as value-relevant and are concerned with the reliability of reported data.
Interestingly, the SEC gave this topic considerable attention in their proposed climate rule. In the proposal, the SEC is requiring “limited assurance” for the first two years, after which they will require “reasonable assurance.” Limited assurance is what auditors do for their quarterly 10-Q reviews whereas the full audit covering a 10-K provides reasonable assurance.
Net-net, well-prepared proxy data, CSR material, and 10-K HCM information that investors consider reliable and trustworthy can directly impact equity valuation.
The current trend toward more non-financial disclosure is going to force tough decisions. Despite investor pressure, we tend to advise against over-disclosure. Monitor what peers are doing and don’t break from the pack unless you’re certain it will unlock tangible benefits.
Nonetheless, shareholders will continue pressing for more disclosure. There’s an inevitability to this in that we expect, some number of years from now, comprehensive disclosure on human capital metrics of interest. Clearly, the same will be true for climate metrics of interest. Shareholders are asking for more granular cuts on representation data, pay equity results, safety incidents, and more.
European shareholders have been traveling down this path much longer than their US counterparts. Europe also has more abundant regulation concerning non-financial disclosure. In this regard, domestically, it seems to be a question of when and not if.
Action Items and Next Steps
Given the importance of non-financial data presented in the proxy, 10-K HCM disclosure, and CSR report, leading organizations are taking certain proactive steps to improve disclosure reliability and reduce risk.
1. Set up a system of controls. In keeping with how Sarbanes-Oxley mandated internal control procedures and an audit of the system of internal control over financial reporting, we suggest voluntarily implementing rigorous controls around all non-financial calculations taking place. This means procedure documents, control totals tests over the data, trending and fluxes to validate numerical reliability, and clear review responsibilities.
2. Leverage calculation best practices. While some non-financial calculations are black and white, others are laden with assumptions. Unfortunately, there are no rigorous standards governing calculation methodologies as we have in accounting via generally accepted accounting principles (GAAP). The limited materials made available by the Sustainability Accounting Standards Board and others do not, for example, prescribe specific approaches for complex topics.
Complex areas where we see significant divergence in methodologies include pay equity, employee engagement results, how to cut and stratify representation data, and advanced pay calculations like the new pay vs. performance disclosure in the proxy.
Our advice is to leverage your external vendors. For example, in addition to seeing a wide breadth of situations and using this experience to inform best practices, we also keep tabs of trends in litigation. Until a standard-setter gives us the equivalent of GAAP in the non-financial space, we think there’s value in monitoring what techniques do and don’t hold up in litigation.
3. Conduct at least two dry runs before going live on a new externally reported metric. In addition to working out process kinks, these dry runs also let you conduct the critical exercise of trending the results and performing root cause analysis on the variance drivers. Imagine disclosing a pay equity result that shows no gender pay gap and then a year later you disclose a 3% gap.
The first question everyone will ask is, “What changed and why?” Not only will you want readily available processes on the shelf to identify change drivers, you’ll also want some comfort that the methodology is durable and not overly sensitive to blips in the data. These offline dry runs are critical to gaining that comfort so you can begin disclosing externally.
4. Prepare and execute manager training. Once you begin disclosure, employees will see the information and have questions. These questions may be unexpected or nuanced in a way that the manager may simply not know how to reply.
We suggest drafting manager talking points and FAQs in advance of going live (internally or externally). The informational aids should address disclosures related to representation, pay equity, employee engagement, health and safety, or any other topic where an employee could express concerns or simply seek more detail.
In the financial world, earnings misses and restatement announcements still top the list of valuation drivers. What we learned in our finance and accounting courses hasn’t gone by the wayside. However, the tea leaves are clear: Investors also care about non-financial data. This data influences their selection of stocks, director reelection decisions, whether to support activists, and how they approach other ballot decisions in the proxy.
Meanwhile, non-financial reporting is still the Wild West relative to its older, more refined cousin, financial reporting. Non-financial disclosures aren’t audited according to attest standards used on financial data, standard-setters haven’t provided rigorous calculation frameworks, and most companies don’t yet have the same level of process rigor and control as they have for their financial reporting.
The good news is that most companies are in similar situations and there’s benefits to being proactive in developing more mature, reliable, and efficient tracking and reporting processes. Making investments today will pay dividends as additional voluntary disclosure momentum picks up and required disclosures come down the pike. We would welcome the opportunity to discuss any of these topics with you and explore how we can be helpful as you build stronger foundations for non-financial reporting.
 Florian Berg, Florian Heeb, and Julian Kölbel, “The Economic Impact of ESG Ratings,” MIT Sloan Working Paper, March 31, 2023.
 Guido Giese, Zoltan Nagy, and Linda-Eling Lee, “Deconstructing ESG Ratings Performance,” MSCI ESG Research Paper, June 2020.
 “Consumers care about sustainability—and back it up with their wallets,” McKinsey, February 6, 2023.
 Ryan Casey and Jonathan Grenier, “Understanding and Contributing to the Enigma of Corporate Social Responsibility (CSR) Assurance in the United States,” Auditing: A Journal of Practice and Theory, (2015) 34 (1).