Relative TSR Plans: Expert Insight

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1 July 2016 Relative TSR Plans: Expert Insight Relative TSR Valuation #105: How to Forecast the Valuation Effect from Stub Periods Introduction In the past, our team has discussed at length the technical valuation issues associated with performance shares that are based on relative total shareholder return (TSR) performance. Some of the prior concepts we have vetted are: Relative Total Shareholder Return Plans: Valuation 101 Relative TSR Plans: Valuation The Impact of Volatility on Valuation Relative TSR Valuation 103: How Design Decisions Impact the Cost of Relative TSR Awards Valuation 103 (addendum): The Impact of Mandatory Holding Periods Valuation The Impact of Macroeconomic Market Forces on your Relative TSR Valuation This paper will evaluate the importance of stub periods on the grant date valuation. To clarify, the stub period refers to the duration of time between the beginning of the performance period (including any beginning average period) and the accounting grant date. For example, a common performance period will begin on January 1 of a calendar year. However, the accounting grant date will not occur until after the compensation cycle and ultimate Compensation Committee approval which may occur in March. The stub period would represent the period of time between January and March. According to Topic 718, an award s fair value must reflect all information as of the grant date, including the stock price movements between January and March in this example. Risk. Reinsurance. Human Resources

2 The challenge is that interim stock price movements can be volatile, making it hard to forecast for the ultimate accounting valuation ahead of time. Depending on your company s approach for grant sizing, it can lead to either pay inequity challenges or financial reporting challenges: 1. If grant sizing is performed using the accounting fair value, there is the possibility for granting significantly more or less shares than anticipated or from the prior year; 2. If grant sizing is performed using the stock price or a defined number of shares are granted regardless of value or price, there is the possibility for significantly more or less accounting cost than anticipated. This study has leveraged Aon s rich data set of actual audited valuations using Monte Carlo simulation, representing over 100 companies and 400 discrete Monte Carlo valuations. In each valuation, we have performed distinct valuations that we describe as the accounting value and the economic value. Accounting Value Economic Value Represents the actual valuation used for ASC718 reporting, including all stock price performance during the stub period. Consistent assumptions with the accounting value above, however, this valuation strips out all stub period stock price performance. Therefore, all companies are starting the performance period with the same TSR (or 0%). This value is a better forecast for modeling compensation expense in future years. In studying the differences between the accounting value and the economic value, we have observed these key explanatory variables (the Impact Variables ): Company TSR over the Stub Period compared to the Median TSR of Peer Group Volatility of Company Correlation of Company and Peer Group Remaining Duration of Time in Performance Period Peer Group Size In the subsequent pages of this paper, you will find detailed estimations as a function of each of the variables above. However, speaking very broadly, we believe the following rules of thumb apply (the following example is building off of the estimated valuations from our prior research using a fair value of 144% of stock price). 2

3 Stub Period Effect Example Company TSR 10% above peer median or 1000 basis points Increase in Fair Value by higher over the Stub Period 4.4% 144% x ( ) = 150% Company TSR 10% below peer median or 1000 basis points lower over the Stub Period Decrease in Fair Value by 4.4% 144% x ( ) = 138% We want to caution that this is a broad simplification, and the actual valuations will vary by each of the key factors discussed in detail below. Results of Analysis We have isolated variables mentioned above to truly understand the impact of stub periods in Relative TSR valuation. Impact Variable #1: Company TSR over the Stub Period Compared to the Median TSR of Peer Group Below we show a graph detailing how outperforming or underperforming the median peer group TSR during the stub period will cause the economic and accounting fair values to diverge. The farther the Company s TSR gets from the median peer group TSR, the greater the disparity between the accounting and economic fair values. 3

4 As mentioned, overall we generally see about a 4.4% change in fair value for every 1000 basis point delta in TSR during the stub period. Aon Mitigating Strategy: The risk of valuation volatility occurs within any stub period. To eliminate a stub period requires one of the following strategies: 1) accelerate the meeting date when the compensation committee approves (grant date); or 2) delay the performance period start date until after the compensation committee approval (grant date). Impact Variable #2: Volatility of Company We divided our data set into the upper quartile, lower quartile, and middle quartiles of company volatilities. Volatility is the measure of price fluctuation over a period of time. Generally, we have observed that lower volatilities will see stub periods have a larger impact on their plans. In the chart below, we can see how our initial 4.4% change in fair value is affected when we focus the data set by company volatility. Volatility Impact on Fair Value Difference Magnitude of Change Assumed Change in Fair Value (per 1000 Basis Point Difference) Top Quartile (Greater than 50% Volatility) % 3.303% Middle Quartiles (Similar peer volatilities) Base Case 0.000% 4.400% Lower Quartile (Lower than 30% Volatility) 1.050% 5.450% Intuitively, a lower volatility company will have a more difficult time catching up any gaps in TSR during the stub period, and likewise will more likely be able to stay ahead of any peers if they start off ahead. Conversely, a highly volatile company can more easily offset any incremental differences in TSR during the stub period. Aon Mitigating Strategy: We believe it is critically important to develop a peer group that has reasonably similar volatilities of stock price. Not only does this create less sensitivity in the payouts, but it strengthens the linkage between pay and performance. Impact Variable #3: Correlation of Company to Peer Group Stock price correlation is the measure at which two stock prices move in relation to each other. Higher correlations indicate that the two measured companies move very similarly, while correlations closer to 0 mean there is no determinable relationship and negative correlations indicate that stock price movements are inversely 4

5 related. We have found that the stub period becomes more impactful when companies have higher correlations. This relationship comes from that fact that plans with highly correlated peers have a lower chance of changing their percentile rank throughout the projected performance period since the stock prices move with such similarity. We have broken down the data into the lower, upper and middle quartiles for average correlation coefficients to see how the initial 4.4% change in fair value is affected by peer correlation. Correlation Impact on Fair Value Difference Magnitude of Change Assumed Change in Fair Value (per 1000 Basis Point Difference) Top Quartile (Greater than 0.65 average correlation) 3.405% 7.805% Middle Quartiles (Between average correlation) Base Case 0.000% 4.400% Lower Quartile (Lower than 0.41 average correlation) % 3.478% Aon Mitigating Strategy: We believe it is critically important to develop a peer group that is reasonably correlated to your company by stock price. Despite the increased effect high correlations have on the Stub Period, it is important to maintain high correlations to create less sensitivity in the payouts and strengthen the linkage between pay and performance. Impact Variable #4: Remaining Duration of Time in Performance Period We also analyzed how the length of the stub period affected the resulting fair values. We sliced the data into sections where the Company granted the award within the first 30 days, between 31 and 90 days, between 91 days and 1 year, and greater than 1 year of the performance period start. Within the model, as the stub period grows, the projected performance period will shrink and therefore reduce the amount of time for companies to alter the ranking from their performance over the Stub Period. As a result, a larger stub period becomes more impactful on the final ranking within the simulation process. On the following page we can see that as the stub period increases, the impact of the assumed change in fair value as a result of the stub TSR increases. 5

6 Stub Period Duration Impact on Fair Value Difference Magnitude of Change Assumed Change in Fair Value (per 1000 Basis Point Difference) First 30 Days Base Case 0.000% 4.400% 31 to 90 Days 2.067% 6.467% 91 Days to 1 Year 2.351% 6.751% Greater than 1 Year 4.449% 8.849% Aon Mitigating Strategy: It may be necessary to have ad hoc grants subsequent to your larger population due to new hires or promotions. Careful consideration needs to be put into the treatment of these ad hoc grants including pay inequity, 162M deductibility, and the potential of accounting cost variability due to the extended Stub Period. Impact Variable #5: Peer Group Size Finally, we analyzed how the number of peers in the peer group affected the resulting fair values. We partitioned the data into awards with less than 30 peers, between 31 and 100 peers, between 101 and 500 peers and greater than 500 peers. With a smaller number of peers, the impact of the stub period TSR has been found to be greater. The reason for this is that if you are competing against more peers, you are more likely to change position in the model s projected stock prices. Another way to think about this is if you are participating in a race with 10 racers, statistically speaking, you are less likely to change your starting position during the race than if you were competing against 500 racers. It is important to note that the size of the peer group will not guarantee a higher or lower fair value, but that the placement during the stub period will have a lower impact on the final projected placement within the model for a larger peer group than it does with a smaller peer group. Below we can see how the size of the peer group changes our initial 4.4% change in fair value assumption. 6

7 Number of Peers Impact on Fair Value Difference Magnitude of Change Assumed Change in Fair Value (per 1000 Basis Point Difference) Less than 30 peers 2.103% 6.503% Between Peers 0.434% 4.834% Between Peers Base Case 0.000% 4.400% Greater than 500 peers % 2.925% Aon Mitigating Strategy: Using a greater number of peers will help to mitigate the impact of the stub period on your final valuation; however, it is important not to let this goal drive your peer group selection. The negative impact on the overall plan due to an inflated peer group, of less than ideal companies, would far outweigh the benefits of mitigating the Stub Period. Putting it All Together Let s look at an example where a company has the following variables: Stub TSR Median Stub TSR TSR Difference Volatility Average Correlation Length of Stub Period Peer Group Size Value 17.50% 27.50% % 14.63% Adjustment to Fair Value Change Assumption 115 Calendar Days N/A N/A N/A 1.050% 3.405% 2.351% 2.103% Initial Fair Value Change Assumption per 1000 Basis Points 4.40% Adjusted Fair Value Change Assumption -4.80% Economic Fair Value as a Percent of Grant Price % Projected Accounting Fair Value as a Percent of Grant Price 95.20% 30 7

8 Under this scenario, we can take our initially assumed changes in fair value from the analysis and combine the changes into one prediction. TSR Difference (17.50% %) 10.00% Initial Fair Value Change Volatility Average Correlation Length of Stub Period Peer Group Size Estimated Change in Accounting Value X [ 4.400% X ( %) X ( %) X ( %) X ( %) ] = -4.80% Therefore, in this situation we approximate the accounting fair value to be below the economic fair value by 4.80%. Although this is not a substitute for a valuation of your performance equity, when we are given the economic assumptions we can better project how those assumptions work in relation to grant timing on your resulting fair values. Conclusion Through our proprietary research, we have identified five Impact Variables for gauging the change in valuation due to the stub period. With the significant scrutiny upon executive compensation, from both a financial reporting and an SEC disclosure perspective, it is imperative to understand these five Impact Variables, and their ongoing effect on your Relative TSR plan. Your consultants at Aon Hewitt can help you create reasonable rules of thumb specific to your plan to help you with your ongoing compensation forecasts. To learn more about the Equity Valuation Services practice at Aon Hewitt and, please visit: radford.com/home/valuation/ 8

9 Contact Information Jon Burg Valuation Practice Leader Aon Hewitt David J Moore Senior Associate Aon Hewitt +1 (415) David.j.moore@radford.com Sean Evans Senior Associate Aon Hewitt +1 (415) Sean.evans@radford.com 9

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