Valuations of TSR Awards: Key Insights on Equity Compensation Trends

Equity compensation — a form of non-cash payment to employees — has long been a cornerstone of attracting and retaining top talent. Incentivizing and rewarding employees by granting them ownership stakes in their company aligns employees’ interests with those of the shareholders insofar as the value of their equity compensation is directly tied to the company’s performance.

In the past, equity awards were issued in the form of stock options or restricted stock. Today, relative total shareholder return (rTSR) awards are one of the most prevalent forms of market-based compensation. In fact, according to a recent study by Equilar, more than 60% of S&P 500 companies use rTSR awards as part of their executive compensation programs.

What Is an rTSR Award?

An rTSR award is a type of performance-based equity compensation that ties the payout to the company’s stock performance relative to a predetermined peer group or index over a specified period.

It aligns the interests of employees with those of shareholders by incentivizing actions that drive long-term shareholder value. Many companies issue rTSR awards, particularly in industries where stock performance is a key metric of success. The appeal lies in rewarding executives based on how the company performs compared to its peers, rather than solely on absolute stock price performance.

Pros and Cons of rTSR Awards

Some of the pros of using rTSR awards as equity compensation include the following:

• Aligns executive compensation with shareholder interests
• Provides a clear benchmark for performance against industry peers
• Provides a direct link between pay and relative stock performance
• Encourages outperformance compared to industry peers
• Promotes a long-term focus on sustainable value creation
  
  

While rTSR awards have many benefits, there are downsides as well. They include the following:

• Complex and subjective process for calculating the value of an rTSR award and determining peer groups
• Potential for excessive payouts or windfalls
• Reliance on peer group selection and external factors beyond the company’s control
• Difficulty in communicating and understanding the award structure
  
  

Determining the Fair Value of rTSR Awards

One of the key challenges in implementing rTSR awards is determining their fair value. Unlike the value of traditional stock options or restricted stock, the fair value of rTSR awards could be significantly higher due to their performance-based nature and the use of market-based metrics. Specifically, the high fair value of an rTSR award is primarily due to the inherent leverage in the payout structure, which can result in payouts that are multiples of the target award value if the company’s stock significantly outperforms that of the peer group.

Because the vesting of rTSR awards are considered market-based vesting awards, which means that their vesting is contingent on the company’s stock performance relative to a peer group or index, their valuation requires the use of specialized valuation models such as Monte Carlo simulations. A Monte Carlo simulation can account for the uncertainty inherent in rTSR calculations and market conditions. It can model potential future stock price paths of both the subject company and the selected peer group or index, considering factors such as volatility, correlation, and dividend yields, which allows for a more reasonable calculation of the value of the award based on the award’s payout structure.

Considerations in Valuing an rTSR Award

Grant Date and Measurement Period

The grant date is the date on which the rTSR award is granted to the employee, and the measurement period is the time frame over which the company’s stock performance is analyzed relative to that of the peer group or index.

Peer Group

The peer group (or an index) is a carefully selected group of companies whose stock performance is compared to that of the subject company. Selecting the peer group is a critical aspect of an rTSR award, as it can significantly impact the award’s payout and value.

Payout Structure

The payout structure defines the relationship between the company’s relative stock performance and the payout level. Common payout structures include linear payout curves, step functions, or capped payouts.

At the time an rTSR award is granted, a specific number of shares, commonly referred to as a “target,” is stated in the equity award agreement. Depending on the payout structure and the company’s performance compared to that of the peer group, an employee receives a certain percentage of those target shares. Those percentages typically range from 0% to 200%. The table below illustrates a payout based on the subject company’s performance compared to that of a peer group.

Using the example in the table above, if the subject company’s performance ranks above the 25th but below the 50th percentile, the target shares earned is determined using a linear calculation between the two percentiles. As you might expect, the higher the potential payout percentage of the rTSR award, the greater the fair value — but only to a certain point. If the upper threshold were increased from the 75th to the 90th percentile, the probability of exceeding that threshold is lower, as is the resulting fair value.

Once the peer group and payout structure of the rTSR award are determined, the fair value of the award must be determined for equity compensation purposes. As mentioned, the most commonly used valuation model is a Monte Carlo simulation. In addition to incorporating the specifics of the rTSR award, the model must include certain inputs or assumptions that will improve the accuracy of the simulation results. These inputs include the following:

• Risk-free rate. The risk-free rate is typically based on the yield of U.S. Treasury securities with a maturity matching the measurement period.
• Volatility. Volatility is a measure of the expected fluctuations in stock price and is typically estimated using historical stock price data.
• Correlation. Correlation measures the degree to which the stock prices of the subject company and its peers move together and is a critical input for modeling the relative stock performance.
• Realized performance. The realized performance is the actual stock price performance of the subject company and its peers during the measurement period, which is used to determine the final payout level.
  
  

rTSR Award Valuation Complexity Demands Expertise

As companies continue to refine their executive compensation programs, they may introduce new terms or variations to rTSR awards, both in design and payout, further increasing the complexity of valuing these awards. As a result, many companies choose to engage valuation firms with expertise in equity compensation to ensure accurate and defensible valuations of their rTSR awards, as well as to stay compliant with accounting and regulatory requirements.

PCE has a broad range of experience in providing fair value financial reporting and related services to businesses and organizations, including public and private companies, private equity firms, early-stage enterprises, and other closely held businesses and partnerships. Our professionals have in-depth knowledge and understanding of the reporting requirements and best practices in such valuations, and we provide a full range of fair value measurement services. Our analyses and conclusions have been widely accepted, withstanding the scrutiny of auditors, the SEC, and other regulatory bodies.

With our team’s background in fair value accounting, we assist clients with valuation matters impacting their financial statements and help them navigate the nuanced financial and strategic issues. And because our firm understands fair value issues, local and national accounting firms regularly refer financial reporting valuation assignments to PCE Valuations.

If you’re thinking about using rTSR awards in your company or would like to know your existing awards have been valued correctly, contact us today.