The recent carnage on European and US stock markets has only highlighted the problems of linking managerial compensation to stock market performance. Many employees who were lured to join new firms with the promise of lucrative stock options now find themselves holding worthless paper—while the firms themselves are wondering what they can do to stop employees from leaving in search of greener pastures.

Stock options are seen as a way of linking managers’ compensation to investor returns. The better a manager performs, the more the stock price will rise and the more the options will be worth. But as many employees of dot-com companies would now attest, stock price movements are a crude measure of how well managers are doing.

Short-term share price movements are driven in large measure by the market as a whole or by the industry sector. A statistical analysis of total returns to shareholders (TRS) for almost 400 companies since 1962 suggests that, on average, over 40 percent of the returns during any one- or three-year period can be explained by market and sector movements. (These are the periods over which share price performance is usually measured for the purpose of evaluating managerial performance.) So if managers are being rewarded on the basis of share price movements alone, they are in large part being rewarded (or penalized) for events outside their control.

Traditional share option schemes do exactly this, and the bull stock market of the past decade has rewarded option-holding employees in all but the most woefully underperforming enterprises. Exacerbating matters is the fact that share prices are driven in the short term more by differences between actual performance and market expectations than by the level of performance per se. In other words, it is the delivery of surprises that moves prices—for example, failing to meet analysts’ expectations or exceeding them.

As a result, companies that perform well consistently can find it difficult to move their share price. The market may believe that managers are doing an outstanding job, but it has come to expect no less, and its approval is already factored into the share price. In these companies, extraordinary management performance might go unrewarded if compensation were based on stock market performance alone.

On the other hand, managers in poorly performing companies might find themselves over-rewarded. This is because stock prices reflect expected future performance. Merely the announcement of a new chief executive officer can be enough to shift a share price by more than 10 percent even before he or she takes the helm—and long before performance has improved.

So how should managers’ performance be measured and rewarded? Not all companies hand out share options. But many link compensation to stock price movements in other ways. The most common stock market measure is TRS: stock appreciation plus dividends paid. This has the same shortcomings as share options, since it too is a measure of how much managers beat or fail to meet market expectations and is affected by general sector and market movements.

TRS is therefore no more accurate a reflection of management performance than stock options. But there is no easy alternative measure at hand. Companies must accept that performance management is a complex business. The best solution is one that amalgamates different kinds of measures while at the same time allowing for their limitations.

To begin with, when stock market measures are used as a basis for compensation, it is important to strip out the effects of general movements in the market or sector in order to quantify the extent to which gains or losses can be credited to management. It is then necessary to assess how a company is rated in relation to others in its sector—that is, to determine the extent to which expectations of future value are already embedded in its share price. Market-to-book ratios—the market value of a company’s equity divided by its accounting value—give an indication of this. If a company is relatively highly rated, then it is unrealistic to expect managers to deliver much higher TRS. But if the company is poorly rated in comparison with its sector, then it would be reasonable for investors to expect higher TRS and to reward or punish managers accordingly.

In addition, given that market measures can award credit before performance is delivered, compensation schemes linked to them should require a certain period of service before options can be redeemed. Finally, companies need to think about the underlying financial performance: return on capital and profit growth. The danger of using these traditional accounting measures is that managers might try to boost short-term profitability at the expense of longer-term shareholder value. It is for this reason that stock options and TRS-related bonuses became popular in the first place.

But the baby is in danger of being thrown out with the bath water. Financial measures remain important because they assess managers on the basis of what managers have delivered rather than what the market believes managers will deliver. To date, financial measures have been conspicuously absent in the assessment of the performance of dot-com companies. Yet it surely can’t be long before investors in these companies start demanding profits as proof of sound management rather than relying on the uncertain promise of things to come.

The use of stock options has proved an excellent way of pushing management teams to get businesses up and running in the new economy. But it is time to move to a new compensation model reflecting the fact that for some companies the share price already reflects much of the potential for creating value. Investors need assurance that managers are being encouraged to deliver on this value. And would-be employees, who rightly doubt how much further the share prices of highly rated stocks can rise, need different incentives to be attracted to such companies.