The Great Recession caused many finance professionals to reexamine their views of risk and return, and even led some prominent investors to declare a “new normal,” which is generally characterized as a period of low growth and low returns. The new normal has broader applicability as well. Many argue that much like the Great Depression, the financial crisis of 2008 and 2009 led to a paradigm shift in the way average Americans lead their lives.
It is within this spirit of reexamination and the new normal that we analyze the trends in current practices in share-based compensation. In our valuation practice, we encountered with increasing frequency over the course of 2010 reporting entities that required assistance in the measurement of complex share-based payment awards. These awards were not the plain vanilla time-based vesting stock options of the past, but rather grants of performance awards (e.g., restricted stock or stock options with performance and market condition vesting requirements).
The goal of this article is to investigate whether the new normal has permeated share-based compensation practices. The specific analytics performed and discussed herein are largely a refresh and extension of an article published by Stout Risius Ross, Inc. (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® Index 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 October 2010) was then compared to the data compiled in November 2006 in order to analyze trends and changes that may have occurred over this volatile time period.1
Our recent review of share-based compensation practices confirmed a number of our expectations following the review performed in 2006, and introduced several new observations. The results indicate that the new normal applies to share-based compensation. Our findings illustrate that share-based payment awards have become a larger component of total employee compensation. Moreover, while stock options are still the most widely used form of share-based compensation, there is an increasing trend for companies to issue restricted stock and/or performance units with performance-based vesting criteria. We also found that companies have only slightly migrated from employing closed-form models, such as the Black-Scholes Option Pricing Model (“BSOPM”), to more flexible techniques, such as lattice models and Monte Carlo simulations, when measuring the fair value of traditional employee stock options. The following narrative details the observed themes.
Employee Share-Based Compensation Expense on the Rise
Based on our analytical review and as illustrated in the above charts, share-based compensation expense increased as a percentage of both selling, general, and administrative (“S,G&A”) expense and total revenue over the past six years. The historical increase is not a surprise given the release of Statement of Financial Accounting Standards No. 123 (revised 2004) (n/k/a Financial Accounting Standards Board Accounting Standards Codification Topic 718, Compensation – Stock Compensation (“FASB ASC 718”)), which requires reporting entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). Accordingly, FASB ASC 718 requires all public companies to record share-based compensation expense on their income statement (and a balance sheet liability if settled in cash). Intuitively, the trend makes sense, particularly as share-based awards are increasingly employed to align management compensation with shareholder interests.
Additionally, when we examined share-based compensation practices by industry classification, we were not surprised to find that the information technology industry is by far the biggest user. The data also indicates that financials and healthcare companies employ share-based payment awards more so than others (and, along with information technology, significantly increased using share-based compensation over the observation period), while companies in sectors such as utilities and consumer staples have tended to exhibit much less share-based compensation expense as a percentage of revenue.
What we did find interesting, however, was the flattening trend of share-based compensation expense over the past four years, particularly given the varying economic cycles experienced and the volatility in corporate revenue, expenses, and earnings over this time period. The trend suggests that companies within the S&P 500® Index may have “peaked” in regard to their utilization of share-based compensation packages within their organizations. On the other hand, the flattening trend may simply be attributable to companies successfully adjusting or modifying existing and new share-based payment awards in an effort to combat rising expenses.
The later theory appears to have some support in the underlying data from the S&P 500® Index companies. Specifically, the average contractual term of employee stock option awards (still the most popular award granted within the S&P 500® Index) declined between 2006 and 20102 from 9.59 years to 9.48 years. Most of the companies within the S&P 500® Index issued stock options with 10-year contractual terms, but a number of companies have decreased the term of their options in recent reporting periods.3
Additionally, the ratio of effective term to contractual term has increased from 54% to 57% between the two study dates. All else held constant, a decline in the contractual term results in a lower option value (and thus lower compensation expense). However, this is mitigated by the fact that a decline in the contractual term often results in a lower effective term for the options, which reduces value and the time frame over which the options are expensed. The latter consideration appears to be less applicable however given the upward trend in the effective term to contractual term ratio.
Another way companies can combat rising share-based compensation expense is to shift from the issuance of time-based vesting awards to performance-based vesting awards. Compensation expense related to performance-based vesting awards is adjusted for the probability that the performance metrics will be met, while time-based vesting awards do not require any probability adjustments, and therefore, typically result in greater compensation expense all else held constant. As discussed in the following section of this article, there has been a trend towards the issuance of performance- and market- based vesting awards relative to time-based vesting awards within the S&P 500® Index.
Continued Shift in Type of Awards Granted
Companies continue to shift away from solely issuing stock options, and instead are utilizing other share-based compensation awards that have either a time-, market-, or performance-based vesting criterion (e.g., restricted stock and restricted stock units).4 Specifically, the number of companies that indicated an issuance of restricted stock increased from 63% to 89% from our 2006 to 2010 study. Further, the number of companies that indicated an issuance of performance awards increased from 20% to 37% between the two study dates. Please refer to the following chart, which illustrates the relative use of the varying types of share-based compensation awards.
Overall, nearly all of the companies within the S&P 500® Index with sufficient disclosure information (i.e., 96%) issued an award other than traditional stock options in their most recent fiscal year. This percentage compares to 76% as of our 2006 review. This is evidence of the fact that companies continue to take steps to address the principal-agent problem within their organizations and are proactively aligning management compensation with shareholder interests.
Given the continued shift in the type of award grants within organizations from simple, time-based stock options to more complex, performance- and market-based awards, one may expect a shift in the general valuation methodologies utilized by companies within the S&P 500® Index. Share-based payment award valuation methodology observations are discussed in the following section.
Flexible Valuation Methods Becoming Increasingly Important
In our recent review, there was a slight decrease in the relative use of BSOPM to measure the fair value of traditional employee stock options (i.e., 85% to 83%). The decline coincides with an increase in companies utilizing other techniques, such as lattice (e.g., binomial) models or Monte Carlo simulations. In fact, a number of companies within the S&P 500® Index commented within their disclosures that the lattice model was a more flexible option than BSOPM in valuing employee stock options. Accordingly, many companies switched from BSOPM to a lattice model at some point between the 2006 and 2010 study dates.5
The decline in the use of BSOPM to estimate the fair value of employee stock options is consistent with our expectations following our 2006 review. However, the extent of the decline is somewhat surprising given the fact that BSOPM is inflexible with respect to factoring in suboptimal exercise behavior or any changes to the inputs (e.g., volatility or dividend yield). In fact, the only way to modify BSOPM to account for early exercise behavior is to adjust the effective term assumption.6 Moreover, BSOPM is not equipped to accommodate changing volatility or dividend yield inputs over the effective term of stock options.
The issuance of the Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 110 (“SAB 110”) in December 2007 may be somewhat responsible for the continued reliance on BSOPM. SAB 110 affirmed that the SEC will continue to accept the “simplified method” (introduced in 2005) to calculate the expected term assumption for stock options. The simplified method formula (presented below) is an attempt to account for suboptimal exercise behavior in the estimation of fair value.
Expected Term = [(Vesting Term + Contractual Term) / 2]
Prior to the issuance of SAB 110, the SEC stated that it would not expect companies to utilize the simplified method beyond December 2007 since the expectation was that reporting entities would be able to rely upon historical exercise behavior observations instead. SAB 110 “softened” this expectation with the comment that the SEC staff understands that such detailed information about employee exercise behavior may not be widely available by December 2007.
Despite the continued reliance on BSOPM for traditional employee stock options, our recent review of the S&P 500® Index did indicate a material increase in the utilization of Monte Carlo simulations for complex vesting awards. Specifically, over 10% of the companies within the index reported the use of a Monte Carlo simulation model to value some portion of share-based compensation expense. This trend is tied to the fact that companies continue to issue more complex share-based payment awards (e.g., performance-based awards), whereby simplified valuation methods may not accurately reflect the true economic value of the compensation expense.
An increasingly common example of such an award is a total shareholder return (“TSR”) award, whereby the final payout of an award (e.g., restricted stock or cash) is based on the future performance of the underlying company’s stock price relative to the TSR of a peer group or market index. In fact, nearly 20% of the companies within the S&P 500® Index that indicated the use of performance-based criteria compared their relative performance to that of a peer group or other market benchmark. Of these companies that reported disclosure, 43% utilized a Monte Carlo simulation model in their estimation of share-based compensation expense.
Conclusion
The increasing trend of compensating employees with share-based payments is designed to more closely align the long-term financial interests of company management with those of its shareholders. In a similar vein, companies are gradually moving from issuing share-based payments in the form of stock options to restricted stock or performance awards with vesting contingent upon either company-specific, market, or relative market performance. Performance criteria often require the company (or its valuation advisors) to use a more complicated valuation model (such as a Monte Carlo simulation model as opposed to BSOPM) in order to appropriately measure the fair value and derive the service period (i.e., the term over which the awards are expensed) of the share-based payment awards.
In the future, we would expect to witness the continued migration from the use of BSOPM to more flexible models as share-based compensation becomes (i) less dependent on time metrics and more dependent on performance criteria and (ii) increasingly material to reporting entities’ financial statements. Additionally, while we do not expect companies to abandon the use of stock options (given their straightforward nature and ease of measurement), we would expect companies to increasingly employ awards with performance- or market-based vesting conditions as companies balance pay and performance with the magnitude of compensation expense.
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.
2 Throughout this article, results for 2010 are based on the most recent fiscal year end statements available as of the 2010 study date (i.e., the most recent 10K filings). Results for the previous years represent data from fiscal year end statements issued in sequential periods prior to the most recent data (e.g., 2008 represents data from the fiscal year end period that was two years prior to the 2010 data). This methodology was used to avoid double counting the data.
3 Companies that decreased stock option terms between the 2006 and 2010 study dates include, but are not limited to, Alcoa, Inc.; AmerisourceBergen Corporation; Bed Bath & Beyond, Inc.; Hewlett-Packard Company; SUPERVALU Inc.; Symantec Corporation; and Wellpoint, Inc.
4 Examples of such companies include Apple, Inc, which discontinued issuing stock options to employees and instead issues restricted stock units, and International Business Machines Corp., which began issuing restricted stock units and performance stock units in lieu of stock options in 2007.
5 These companies include, but are not limited to, Best Buy Co., Inc.; Automatic Data Processing, Inc.; CarMax, Inc.; Staples, Inc.; Comerica, Inc.; and Corning, Inc.
