Are the targets for EPS hurdles within the long term incentive plans of Australia’s top companies set high, low or about right? Egan Associates investigates.
Examining 2015 annual reports, of the top 100 companies by market capitalisation, 40 disclosed the use of an EPS hurdle in their long term incentive plan.
29 companies* disclosed a prospective EPS threshold and maximum for the future vesting of grants. These hurdles were either expressed as a compound annual growth rate (CAGR) or could be converted to a CAGR.
The lowest EPS thresholds were around 2.5% per annum, with the highest rising to 10%. The lowest maximums ranged from 4.5% with the highest being 20%.
The distribution of the EPS performance conditions can be seen below, with “difference” depicting the increase in growth required to reach maximum from threshold.
Most shareholders would consider an EPS CAGR of 20% to be ambitious. However, if investors utilise analyst forecasts to determine whether growth targets are reasonable, they may not consider this to be the case.
In order to gain an idea of how close EPS targets are to analyst forecasts, Egan Associates calculated the CAGR required to reach the consensus forecast three years on from the companies’ latest published annual report (provided by S&P CapitalIQ). This was then compared to the growth rate required to reach threshold and maximum vesting of long term incentives as published in the annual report.
The EPS CAGR for threshold vesting was lower than the growth required to meet forecasts for 22 of the 29 companies. The growth for maximum vesting was lower than that required for forecasts for 18 of the 29 companies.
Does this mean that EPS targets were not ambitious enough for two thirds of companies examined?
In terms of rewards for threshold EPS performance, It is Egan Associates’ observation that threshold EPS CAGR hurdles are set at a level which the Board believes represent an attainable outcome arising from a sound though not superior performance.
We have also observed that the number of securities that vest for threshold performance has reduced over the last five years. Previously, 50% securities would vest at the threshold for most companies, while it is now becoming increasingly popular to have 25% or less of securities vest at threshold performance, with the balance vesting on a pro rata basis through to the stretch or maximum hurdle. This may reflect an acknowledgement that threshold EPS hurdles are attainable under a sustainable though not necessarily a growth model, which may not match analyst expectations.
In the case of the stretch hurdle rate there may be a number of issues at play:
- In order to deliver a better outcome for shareholders, the Board’s compound EPS definition may be stricter than the traditionally understood formula – something we will write about in more detail in a later newsletter.
- The Board will have carefully chosen targets that fit the company’s long term trajectory, with the goals easier to meet over some cycles than others. The Board will have a firmer grasp than external parties of planned initiatives, which may require the sacrifice of earnings growth to fund long term returns.
- The company’s assumptions may be more conservative (and/or knowledgeable) around the effect of global developments on the company’s trajectory (for example, the effect of Brexit on future EU patent approvals).
- Although forecasts will change often based on the information at hand, the Board will have chosen targets well in advance of the beginning of the performance period in order to properly document the amount of equity to be granted and performance conditions, thereby hopefully avoiding future disputes.
- The Board may hold reservations about setting stretch targets too high in case they encourage risk taking or gaming of the measure with share buybacks or creative accounting.
- The Board may also be concerned about losing executives to competitors if hurdles are perceived as being significantly more difficult than the rest of the industry. Hurdles may be the end result of negotiations with management around what they believe is achievable.
The setting of performance targets is never an easy process and requires considered thought, sometimes having to manage conflicting perspectives. It is difficult for Boards to navigate these decisions and sometimes they do not get it right. However canvassing stakeholder views is generally the best method of achieving an incentive that will motivate rather than discourage a leadership team.
*The remaining 11 companies with an EPS hurdle for their LTI awards consisted of the following:
- 2 companies that used relative EPS as a performance condition, comparing the EPS of the company to a peer group of companies.
- 1 company that utilised an EPS gateway, where the EPS has to exceed that of the previous year for long term incentives to vest.
- Five companies that disclosed the threshold and maximum vesting condition retrospectively. For example, they would disclose the target for the 2012 LTI grant in the 2015 annual report as that tranche would have vested.
- Three companies that did not disclose any form of EPS target
As a sidenote, of those companies utilising EPS as an LTI performance hurdle, just under a quarter disclosed that underlying EPS would be used, although the actual proportion may be higher as disclosure was not always clear.
Two of the top 100 companies did not disclose information on their long term incentive plan hurdles.