March 01, 2014

Introduction

Stout published an article entitled "Has Share-Based Compensation Entered the “New Normal” Too?" in the Spring of 2011 where we examined shifting trends with respect to share-based compensation practices. The 2011 article focused on the evolving equity award environment from 2006 to 2010 for the constituents of the S&P 500® Index. Observations included an overall increase in the level of share-based compensation relative to total employee compensation. Additionally, it was noted that while stock options were still the most widely used form of share-based compensation, there was an increasing trend for companies to issue restricted stock and/or performance units with performance-based vesting criteria.

In 2013, we conducted research similar to that performed in previous studies in an effort to observe current trends in share-based compensation practices. The specific analytics performed and discussed herein were largely a refresh and extension of an article published by SRR in the Spring of 2007 (Trends In SFAS 123(R): Is the Black-Scholes Model Still King?).

To this end, we reviewed public filings for each component corporation of the S&P 500 in order to analyze the variety of share-based payment awards granted. We also investigated the valuation methods and inputs reporting entities disclosed with respect to the Fair Value measurement of share-based compensation. The current data (compiled in July 2013) was then compared to the data compiled in November 2006 and October 2010 in order to analyze trends and changes that may have occurred over these volatile time periods.1

The more notable observations from the instant study include the increase in the use of stock options that have a performance-based vesting requirement as well as the continued increase in the issuance of performance-based shares. In this age of investor activism, these trends intuitively make sense as companies continue to modify compensation structures to most closely align management compensation with the interests of shareholders.

Employee Share-Based Compensation Expense Remains Consistent; Form Shifting

Based on our analytical review and as illustrated in the following charts, share-based compensation expense, both as a percentage of selling, general, and administrative (S,G&A) expense and total revenue, has remained relatively consistent over the past seven years. As a refresh, Financial Accounting Standards Board Accounting Standards Codification Topic 718, Compensation – Stock Compensation (FASB ASC 718) requires that all public companies record share-based compensation expense on their income statement (and as a balance sheet liability if settled in cash).

Median Share-Based Compensation Expense Ratios

Despite this consistency in relative expense levels, we did observe a material shift in how share-based compensation is awarded. Specifically, fewer companies are relying solely on stock options that have a time-based vesting component. While stock options are still widely issued, many more companies are incorporating market and performance condition, (collectively referred to as performance) and vesting criteria (in the form of stock price performance or operating metrics such as certain levels of revenue or earnings), in addition to time-based vesting. Specifically, 12% of S&P 500 companies reported issuing equity-based compensation with performance-oriented vesting criteria for stock options in 2013, a doubling from 6% observed in 2010.

Shifting Trends in Vesting Requirements of Stock Options

Our current research also indicates that while the number of companies issuing stock options is largely unchanged, there are significant increases in the number of companies issuing performance shares in addition to stock options. As illustrated in the chart on the following page we observed 59% of companies in 2013 compared to 37% of companies in 2010 issued performance shares. Moreover, our research shows that the use of other forms of share-based compensation (most notably stock appreciation rights (SARs)) is also on the rise.

Performance-based criteria include the issuance of shares or cash payments contingent upon increases in stock price or relative stock or total shareholder return (TSR) performance as measured against a defined public company group. The measurement of the Fair Value of such instruments is more complex than “plain vanilla” equity instruments because no formula exists to quantify value. It becomes incumbent upon the reporting entity, or their valuation advisor, to construct a model that reflects and captures the economic attributes of the performance unit. This exercise is most typically performed using scenario or Monte Carlo analysis. A Monte Carlo simulation is a class of computational algorithms that rely on repeated random sampling to compute the respective results.

Based on the facts and circumstances of the provisions of the performance unit award, such as variable vesting or award percentages, a Monte Carlo simulation can analyze and produce the expected vesting and award percentages associated with the performance unit award over the applicable time period where the mean outcome is the Fair Value of the award.

As an example, in order to simulate the outcomes for a TSR award for a subject company and the company peer group, it is necessary to calculate the lognormal distribution of the expected stock price for the subject company, the company peer group, and an applicable stock market index (Reference Index). The distribution is based upon a calculated mean expected stock price and the volatility applicable to each company. Additionally, it is advisable to consider the correlation between the subject company, the company peer group, and the Reference Index and apply correlation factors in the simulation of the expected results.

The mean expected stock price for the subject company, the company peer group, and the Reference Index is then calculated utilizing the applicable term-dependent, risk-free rate of return as of the measurement date, most often the grant date of the award. The risk-free rate is then used to increase the beginning stock prices over the applicable time period, resulting in the mean estimated stock price at the end of the applicable time period. The mean estimated stock price is then utilized (as is the estimated volatility) to estimate the lognormal distribution of expected stock prices.

The increasing trend of issuing performance-based shares or units can be observed in the chart on the following page. In this regard, for companies whose compensation structure includes market-based vesting of performance awards, 49% of these companies reported using a Monte Carlo model in 2013 as compared to 43% in 2010. Overall, 25% of observed companies reported using Monte Carlo analyses in their valuation of their share-based compensation expense. This is up from 11% in 2010.

While Changes Abound; Some Things Stay the Same

Overall, we did not witness significant changes in share-based compensation expense levels by industry, with the information technology industry leading the way again. However, we did note a marked decline in the financials space, which may reflect ramifications from the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which was signed into law by President Obama in July 2010. While this extensive piece of legislation impacts many facets of the financials industry other than share-based compensation, the Dodd-Frank Act requires additional disclosures related to incentive-based compensation arrangements by banks and similar financial institutions as well as limits share-based compensation that encourages an excessive amount of risk taking that may lead to significant losses for the reporting entity.

Analysis of Forms of Share-Based Compensation

Similarly, there has not been a material change in the average contractual life (9.57 years) or estimated effective life (5.43 years) from 2010 to 2013. Moreover, our current research indicates that the Black-Scholes Option Pricing Model (BSOPM) is still the most commonly used tool to measure the Fair Value of stock options, followed by binomial/lattice models and Monte Carlo based valuation techniques.

Share-Based Compensation Expense as a Percentage of Revenue

Stock Options Valuation Method

Conclusion

The increase in the issuance of stock options that have a performance-vesting criteria and other performance-based stock grants indicates that more complex valuation methods are needed in order to value these instruments and satisfy financial reporting requirements. The increase in the reported use of Monte Carlo valuation techniques is logical in the context of the broad shift away from share-based compensation with time-based vesting requirements to share-based compensation that includes a performance condition. As more companies shift to performance-based share incentives in order to align executive and shareholder interests, the complexity of the methods used to value share-based compensation is expected to continue to increase.

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1 It should be noted that adjustments were not made to hold the sample companies constant. As such, there may be an element of measurement error related to any reshuffling of the S&P 500® Index between our research dates.