An Introduction to Monte Carlo Valuation for Relative TSR Awards

Over the last 10 years, companies have gotten creative about rewarding their employees, particularly with equity compensation. Gone are the days of simply granting restricted stock or stock options. Now, it’s commonplace to see performance-based awards that vest depending on the achievement of certain company or market metrics, and relative total shareholder return (rTSR) is one of the most prevalent forms of market-based compensation.

An rTSR award ties the final payout, usually via number of shares, to the issuing company’s stock returns relative to a group of peers over a set period. In other words, the better the issuing company performs against its competitors, the greater the payoff for the award recipient.

But how do you value an award containing a market condition like rTSR? The standard approach is to use a Monte Carlo simulation. In this issue brief, in plain English, we unpack what a Monte Carlo simulation does and how it treats the various features of a TSR award.