Valuation Method for TSR Plans May Produce “Surprising” Results

Companies with relative TSR plans may experience a valuation gap when constructing their SEC Pay Versus Performance tables, according to a recent FW Cook blog. The article cites a recent analysis with Infinite Equity, an equity valuation solution provider, to review the differences in results using different valuation methods for relative TSR plans. The authors compare the “fair value” accounting method that is required in the compensation actually paid (CAP) calculation within the new SEC-mandated disclosure table against the “intrinsic value,” a common method employers use to estimate awards that are “in-flight.” The “fair value” method typically requires complex Monte Carlo simulations that calculate a value for each equity award by averaging the results of thousands of computations from the company and peer group stocks simulating various prices and total shareholder return outcomes. The pay versus performance (PVP) table requires that these calculations are done at the start of each performance year and compared to the value at the end of each year. This differs from the frequently used “intrinsic” practice that considers current percentile ranking of TSR and multiplies the current stock price by the payout percentage.

Infinite Equity illustrates the payout levels under the two different methodologies using a sample table that highlights how the projected payouts change over time as the performance period approaches. The table shows the largest variances between the fair value and intrinsic value when a company’s current TSR ranking is very high or very low and there is significant time remaining in the performance period. Some interesting findings from their example:

• Awards tracking with little or zero payout based on 30^th percentile TSR would reflect payout values near 100% of target under the PVP table.
  
  
• Awards tracking above the 50^th percentile for TSR reflect projected payouts below what a company would expect to pay out under the intrinsic approach.

There are several reasons for the divergence in values which are inherent in the Monte Carlo method.

• Percentile rankings gravitate toward the mean, so companies ranked highly have more downside risk while lower ranked companies have greater upside.
  
  
• The expectation that stock prices, on average, will increase over time, indicating that the current ranking is worth more in the future.
  
  
• The concept of a compounding effect with above-target payouts built into the simulation since strong relative performance is typically correlated with higher stock prices.

The blog suggests it may be helpful for companies with TSR plans to build a table similar to the Infinite Equity example, as a placeholder for estimated fair values and to develop early insights into how equity awards may impact the calculations in the PVP table.