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Article | Executive Pay Memo North America

Avoid unwanted surprises: Understand what drives relative TSR valuation

Executive Compensation|Retirement
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By Stephen Zwicker , Mark Daniels and Kevin Ryan | November 19, 2019

Knowledge and the right tools can help you manage the impact of market changes on the value of your stock compensation grants and effectively incorporate responses into risk management programs.

Relative total shareholder return (RTSR) remains the most popular metric for performance based long-term incentive awards, so it benefits companies to thoroughly understand how different market conditions can impact the valuation of these stock compensation grants.

Under Accounting Standards Codification Topic 718 – Stock Compensation – the expense for an RTSR award is based on its fair value on the grant date determined using a valuation model such as Monte Carlo simulation. This same value is used for disclosing compensation in the proxy statement. Typically, the fair value will be greater than the underlying stock price. Companies almost universally question why this is the case, so this article describes why that relationship exists and some of the factors that influence the size of the Monte Carlo premium.

Let’s start with a fairly typical plan design for XYZ Corporation (XYZ) with the following vesting schedule (Figure 1).

XYZ percentile ranking              Vesting percentage
Less than 30th percentile 0%
30th percentile 50%
50th percentile 100%
At or above 80th percentile 200%

Vesting percentages are interpolated between the 30th and 50th percentiles and between the 50th and 80th percentiles.

Figure 1. Vesting schedule for XYZ Corporation

If we start with the simple premise that XYZ has an equal chance of performing at any TSR percentile ranking, then this plan will vest at 100%, on average. So why would a Monte Carlo valuation typically show a fair value between 110% and 130% of the stock price? The reason is the relationship between vesting and XYZ’s stock price performance. More shares will vest when XYZ’s stock price performs well and fewer shares will vest when it performs poorly.

Let’s look at how that impacts the valuation (Figure 2).

XYZ percentile Probability Average vesting Average stock price1 Average fair value1
0 to 30th 30% 0% 60% 0%
30th to 50th 20% 75% 80% 60%
50th to 80th 30% 150% 120% 180%
80th to 100th 20% 200% 150% 300%
Total 100% 100% 100% 126%

1As a percentage of the grant date stock price.

Figure 2. How strong stock performance impacts valuation

In this example, the fair value is 126% of the stock price. As the table demonstrates, the contribution to the fair value is heavily weighted to the scenarios where XYZ ranks at or above the 50th percentile. Not only are participants vesting in more than the number of target shares granted, but those shares are likely being paid when XYZ’s stock price has increased, often substantially.

So what is the Monte Carlo simulation process doing? It is simply uncovering the true value of the awards being granted. The value of the RTSR vested performance share award described above is greater than the value of a simple time-vested share award, where one share is earned regardless of stock price performance. Another way of thinking about this is that if an investor was offered the opportunity to buy such a RTSR award, more would be paid than the underlying stock price because of the potential upside.

Now that we understand why there is a Monte Carlo premium on the fair value, let’s look at a few factors that influence the size of that premium. We’ll describe the effects from these factors on the sample valuation table (Figure 2).

Stock price volatility

Volatility is a measure of how much the stock price is expected to fluctuate, and can impact valuation in two ways: a company’s absolute volatility and volatility relative to peer companies.

Higher levels of absolute volatility will increase the fair value. This assumes that volatility increases for both the company and peers, so that relative volatility is constant. More volatility means more expected dispersion in future stock prices. The average stock price range that was 60% to 150% in Figure 2 will widen, so the plan’s upside potential that was driving the fair value will increase. For example, if the average stock price above the 80th percentile is now 175%, the average fair value in those scenarios increases from 300% to 350%.

Conversely, higher levels of relative volatility will reduce the fair value. This assumes that volatility for peers decrease, so that absolute volatility for the company is constant. More volatility relative to peers increases the likelihood of performing at the extremes, with significant increases at lower percentile rankings and smaller increases at higher percentile rankings. A more volatile company might significantly beat peers on occasion, offset by more scenarios of underperforming its peers. For example, if the probability column in Figure 2 changes from 30%/20%/30%/20% to 40%/15%/20%/25%, the fair value decreases from 126% to 120%.

The lesson here is that both the volatility of your company and peers needs to be examined. There often isn’t much that you can do about absolute volatility. If overall market volatility increases like it has recently, we would expect most fair values to increase because absolute volatility will increase while relative volatility may stay fairly constant. You may be able to partially manage relative volatility through peer company selection. Volatility changes are driven by market, industry and individual company effects. Selecting peers within your own industry (and as similar to your company as possible) will help increase the likelihood that volatility changes will affect all companies and not just you.

Stock price correlation

Correlation measures how much stock prices move together. Higher correlation between a company and peers and among the peers themselves reduces the fair value. When stock prices are more correlated, the average stock price distribution across the percentile ranking outcomes shrinks. Good stock price performance doesn’t always end in a high percentile ranking, because other peers may have done well also, and vice versa. The average stock price range that was 60% to 150% above will narrow, so the upside potential of the plan that was driving the fair value will decrease. For example, if the average stock price above the 80th percentile is now 125%, the average fair value in those scenarios decreases from 300% to 250%.

Grant date total shareholder return

Most RTSR plans have a grant date that is after the beginning of the performance measurement period. For example, TSR measurements begin on January 1 per the award agreement, but grants aren’t approved by the board until March 1. Actual TSR experience between these two dates is reflected in the valuation. For a three-year plan, a two-month gap period is already in the books, and TSR performance only needs to be simulated over the remaining 34-months.

When the company is doing well relative to peers during this gap period, the likelihood of ending up at a higher percentile ranking increases, and vice versa. For example, if the probability column in Figure 2 changes from 30%/20%/30%/20% to 25%/15%/35%/25%, the fair value increases from 126% to 147%.

Actual TSR performance between the beginning of the performance period and the grant date is largely unpredictable and will likely be different from one year to the next. This can cause large swings in the fair value from year to year. Some companies manage this effect by eliminating the gap period and starting the TSR performance measurements on the grant date.

Plan design

So far we have talked about the major valuation inputs to the Monte Carlo simulation process. Clearly, plan design also helps manage the Monte Carlo premium over the stock price. We’ll save the details for a future posting, but some of the design features that influence fair value include:

  • Vesting minimum, target and maximum percentile thresholds
  • Dividend treatment
  • Vesting percentages
  • Negative TSR vesting caps
  • Overall payout caps
  • Use of RTSR as a modifier

Understand how RTSR awards work and stay on top of performance

RTSR awards appear to be here to stay. Companies that are just starting to offer such plans would be well served to understand how the valuations work. And companies that continue to offer such plans should understand how economic changes can impact the valuations from year to year. And while a better understanding of the valuation process can help companies manage unexpected outcomes and contribute to their holistic risk management efforts, it is also important to stay on top of plan performance to evaluate actual outcomes. To assist in these efforts, the Willis Towers Watson’s TSR Performance Monitor application can provide you with daily performance updates for your RTSR awards. Details of how the application can improve your TSR monitoring are available below for download.

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Title File Type File Size
Willis Towers Watson TSR Performance Monitor Brochure PDF 1.8 MB
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