Pay Daze

Linking pay to performance is harder than it looks.

Don Durfee is research editor of CFO.

Setting Up Hurdles
Examples of performance plans.
Company Compensation Type* Performance Period Performance Conditions
General Electric Performance shares 5 years Half of award vests if average cash-flow growth from operations is 10%, half if TSR matches TSR for the S&P 500.
Agilent Technologies Performance shares 3 years Shares vest based on TSR relative to a peer group. At the 25th percentile, the “threshold” award is paid. At the 50th percentile, the target amount is paid; and at the 75th, 200% of target.
Boeing Performance units 3 years Units pay out if the company hits an absolute (but undisclosed) level of economic profit.
Sara Lee Performance shares 3 years Shares vest if diluted EPS growth relative to a peer group meets an undisclosed target.
Fairchild Semiconductor Performance shares Undisclosed Shares vest based on an absolute (but undisclosed) earnings before interest and taxes target.
*Performance shares are paid as full-value shares, performance units are paid in cash, and performance options are stock options with performance-contingent features.
Source: Company proxy statements

Back to the Drawing Board
Tying stock awards to performance requires new calculations.

Companies that consider linking equity awards to performance should prepare to dig in for deeper computations of the compensation’s fair value.

For ordinary options, fair-value calculations are straightforward, with values plugged in from either the Black-Scholes options-pricing model or a lattice model to produce the result. But when vesting is contingent on a relative market condition — how much the growth of company total shareholder return exceeds TSR for a group of peers, for example — the computation of fair value must include the probability that options won’t vest. And for that, the standard models usually won’t do.

The reason is that both the Black-Scholes and lattice models reflect a small number of variables, including current stock price, option strike price, and share volatility. But when vesting contains a time element, and such factors as a peer group’s average stock-price volatility compared with the company’s volatility, a more flexible approach is needed.

Typically, that calls for a Monte Carlo simulation, allowing analysts to build models with many variables. A computer creates a forecast by generating random values for the variables and then running the model thousands of times to create a probability distribution. The most difficult part is the modeling. “It’s time-consuming to build the model from scratch,” says Stacy Powell of actuarial consulting firm CCA Strategies, “but once you have it, it’s not much more difficult than using the lattice method.”

Companies have more leeway basing compensation awards on internal company goals. Instead of prescribing a certain method, FAS 123R says that companies must show they are using their best estimate of the likelihood of a payout. For an earnings-per-share-linked goal, that might mean using the firm’s own forecasting methodology. For nonfinancial goals, it might be little more than an educated guess. “What’s important is that you disclose any assumptions that went into the probabilities you’re using,” says Powell. — D.D.

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