Generally, when measuring long term EPS performance, companies will calculate a compound annual growth rate using the formula below:
(EPS in the final performance year/EPS in the base year)1/n -1
Where n is the number of years between the base year and the final year in the performance period.
An obvious issue with this is that if there is negative EPS performance in the base year, the equation is incalculable. This makes it unsuitable for companies that have made a loss or are likely to make a loss in the near future.
However, the formula also has another major pitfall that will affect even companies with stable earnings: it doesn’t matter what occurs in the years between the base year and the final performance year in the performance period.
By excluding some years from affecting vesting, this formula provides incentives for executives to game the measure, for example by pushing costs into base years so that it is easier to achieve the necessary growth by the final year. It also means that a company could make a loss in an intermediate year and still be paid a long term incentive based on the EPS in the final year. In addition, we have observed one application of an EPS hurdle in a top 100 company which uses the point-to-point methodology and also provides for retesting. This adds another year that may have no impact on final vesting.
It is likely that many investors believe that EPS performance over the whole performance period is considered when calculating earnings performance. They may further believe that executives must achieve an EPS that is at least equal to that in the previous year plus a certain percentage uplift – that is, an annual growth rate compounding each year over the 3-year period.
For example, using the 2015 Financial Year as the base year and assuming 10c earnings per share, a 6% compounded rate of growth to reach threshold vesting would require earnings in the 2016 FY of 10.6c, earnings in the 2017 FY of 11.24c and in the 2018 FY 11.91c. Over the total performance period, earnings per share would amount to 33.75c (10.6c+11.24c+11.91c).
The Board might require the management team to at least meet each of the annual targets in order for any of the incentive to vest, or could state that if the target was missed in the first year, as long as the shortfall is made up in the following years and the cumulative EPS total of 33.75c is reached, the threshold number of incentives will vest.
In contrast, if the CAGR formula above is used, the company could have negative EPS in FY 2016 and FY 2017 and it would not affect vesting as long as the EPS reaches a minimum of 11.91c in FY 2018.
If this were the case, it is clear that the model incorporating EPS results from all three years within the performance period will deliver a superior level of performance than the traditional CAGR formula. The base year is still important, but management teams must improve the aggregate EPS result in order for their incentives to vest.
Egan Associates has had discussions with Boards about this performance condition where it became clear that this is what the Boards wanted to achieve when they nominated an EPS hurdle.
If Boards do want to diverge from EPS market practice to achieve a better performance outcome (whether through the above suggestion or any other alternate calculation), they must make the methodology for calculating EPS growth clear in the share plan rules/and or the offer letter for grants. The methodology and reasoning behind the methodology must also be clear in the annual report so that shareholders also understand the true difficulty of the performance condition.
Only by being completely transparent will Boards both reduce the likelihood of disputes over whether performance conditions have been met and ensure shareholders are kept abreast of the Board’s incentive strategy.