Valuation
Equity award valuation is a challenging compliance area in general, but increasingly challenging for companies with equity programs which incorporate the issuance of options and performance-based awards. Specific modeling best practices are essential to achieving a compliant outcome in the external audit process, while ensuring the valuation is reliable and not overstated or understated.
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Do you Grant Stock Options?
Does your expected term leverage historical data in a way that filters/adjusts non-representative data?
- While expected term estimates should be grounded in empirical data, not all data faithfully represent go-forward future expectations. Expected term estimates should be developed based on a careful analysis of representative historical data.
Does your expected term estimation model match the characteristics of the awards being valued?
- Multiple methods exist for estimating expected term. The appropriate one depends on how many vesting schedules are used, whether changes have been made to the contractual term, and quantity of historical data available.
Do you have foreign-filing subsidiaries under IFRS 2?
- Most expected term estimation methods used for US GAAP purposes are not compliant under IFRS 2.
- IFRS 2 requires graded amortization, which in turn requires estimating expected term separately for each tranche within an award. This approach has historically been uncommon under US GAAP, although perfectly compliant.
Have you tested recently the competing merits of historical and implied volatility?
- The appropriate weighting of historical and implied volatility has changed for many companies post the onset of the recession.
- Implied volatility continues to be a powerful estimation approach, but the SAB 107 criteria (option moneyness, trading volume, maturity, and date synchronization with the options being valued) are the subject of increasing audit scrutiny.
- Historical volatility may smoothen the volatility estimate and capture a steady-state average volatility in the stock, but on the other hand, may pose problems for firms that are continuously evolving and changing.
Have you tested whether different employee groups exhibit different exercise or forfeiture patterns?
- Our research has shown that whereas only approximately 30% of companies have distinct exercise differences across employee groups, over 75% have such differences in forfeiture patterns.
Have you tested the merits of using a lattice model?
- The science surrounding lattice-based approaches has standardized, making these analyses much simpler to perform than at ASC 718 adoption.
- As a principles-based standard, companies may be required to perform such an analysis under IFRS.
Do you Grant Awards with a Market Condition?
These awards must generally be valued using a lattice model or Monte Carlo simulation. Important issues to consider and address in the valuation:
- Is your market condition measuring absolute total shareholder return (TSR) or relative TSR?
Relative TSR provisions require modeling not only your company’s volatility but also the volatilities of the firms being compared to (and the correlations among their volatilities). The more peer firms, the larger the corresponding “correlation matrix.”
- In order for the calculated correlation matrix to be useful within the Monte Carlo simulation, it must be positive definite. Large correlation matrices can present unique valuation challenges if they are not positive definite, and in that case, Equity Methods must perform complex statistical adjustments to make the correlation matrix conform to the needs of the simulation model. If this is not done properly, any valuation result produced from the model will not be appropriate for financial reporting purposes.
Does your market condition contain a catch-up provision?
- Catch-up provisions can blur the award tranches, since outcomes on one tranche/goal have spillover implications to other tranches. This complicates the valuation since tranches are typically valued separately from one another.
Do you Grant Cash-Settled SARs?
Do you use a lattice model to update the expected term/award value each period?
- The expected term should not solely decrease based on the passage of time, but also consider changes in the award moneyness. A lattice model can track how both the passage of time and change in moneyness affect expected term/award value.
Do you synchronize the volatility and risk-free rate with the updated expected term each reporting period?
- If using historical volatility, the historical period should generally commensurate with the most current expected term assumption.
- The risk-free interest rate should be computed from a zero coupon bond with maturity generally equal to the expected term.
Do you Grant Restricted Awards/Units?
Do you pay a dividend on your company stock but not allow RSA/RSU holders to earn dividends on their awards?
- The value of such an award is the stock price on the date of grant less the present value of expected dividends. Many companies incorrectly use the stock price on the date of grant without subtracting out foregone dividends.
Have you tested whether different employee groups exhibit distinct forfeiture patterns?
- Our research finds that over 75% of the time executive/non-executive forfeiture rate differences are observed in the data.
Other potential question areas
Do you ever acquire companies and assume their outstanding awards?
- The valuation on the date the awards are assumed should leverage a lattice model due to the awards typically being underwater or in-the-money. Traditional expected term estimation methods used to value new at-the-money grants tend to yield unreliable results when applied to underwater or in-the-money awards partially into their life.
Do you ever modify awards?
- A modified award must be valued at modification twice: first, reflecting the pre-modification terms, and second, reflecting the post-modification terms.
- This usually requires a lattice model due to the unreliability associated with applying expected term estimation methods used for new at-the-money grants to awards that are underwater (or in the money) and partially through their life.
Do you struggle with translating compensation strategy developed for NEOs outside the C-suite?
- Both traditional stock options and cutting edge performance-based awards can create considerable angst outside the C-suite due to the average employee having little control over the targets, and yet plain vanilla restricted stock is not always preferred due to the relatively weak incentives created.
- Solutions are always case-specific, but require consideration of the seniority of award recipients, similarities/differences between employee groups receiving equity, share pool and overhang concerns, and the role of equity compensation as a part of total rewards.
Relevant Case Studies
An Integrated Approach to ASC 718 Compliance
Relevant Whitepapers
Introduction to Expected Term | 2010
Expense Recognition for Market and Performance Awards | 2010
Introduction to IFRS 2 | 2010
Underwater Option Exchanges: Baseline Theory and Implementation Approaches | 2010
Introduction to Equity Award Valuation Models | 2010
Introduction to Volatility Estimation | 2010
NCEO Issue Brief: Volatility and Fair Value Estimates for Stock Options in a Changed Market | 1996
Relevant Issue Alerts
ECIA: Making Sense of Forfeiture Rates | 2010
ECIA: How Unrefined Expected Term Approaches Create Audit Risk | 2010
ECIA: Best Practices in ASC 718 Forfeiture Rate Estimation | 2009
Equity Methods Underwater Exchanges Survey Results | 2008
ECIA: Identifying and Optimizing a Fragmented ASC 718 Process | 2010
