Fair Value – is it Fair?

Egan Associates is concerned about the application of modified valuation techniques drawing on accounting standards for the purpose of allocating an incentive opportunity to an executive.

Is using fair value for LTI allocation fair?

Essentially, this means Boards are valuing securities for the purpose of allocation at a discount to the current share price – they’re discounting the value of the securities by the value of the dividends forecast for the performance period and for the possibility that the performance hurdle won’t be met.

For example, a Top 50 company uses a Monte Carlo simulation to account for both these issues. Assuming an Executive’s LTI potential is set at $1,000,000 and the current share price $10, on advice, the Board would calculate the number of share rights to be granted to executives by dividing the LTI opportunity by the fair value of the rights calculated via the Monte Carlo method less forecast dividends over the performance period. Monte Carlo might supply a notional value of $4.75 for the rights governed by a Relative Total Shareholder Return hurdle and $5.75 for rights governed by a Earnings Per Share hurdle. Using these prices, the executive would be granted roughly 190,000 share rights.

If instead the actual share price immediately prior to the grant date on a 10 VWAP was used ($10.00) then the executive would only be granted 100,000 share rights – just over half those awarded using the modified Monte Carlo simulation.

A Board may form the view that to incent their top talent they need to grant 190,000 share rights where the underlying shares have a current market value of $1,900,000. However, they are not disclosing the full value of the reward. Our concern is lack of transparency, not the underlying value of the award.

It is Egan Associates’ view that many shareholders do not understand the differentiation in the application of accounting standards for expensing equity instruments granted under a long term incentive plan and the use of those standards modified for LTI equity allocation purposes. They do not understand the additional value offered to executives under the latter.

In our judgment the award of rights to future shares under a long term incentive plan represents a future opportunity for the executive to receive shares equivalent to the nominal value on the basis of today’s share price if future performance standards are met.

If a shareholder has $1 million invested in shares, under the illustration above they will hold 100,000 shares. If the executive receives an incentive of similar value for meeting required performance conditions, then on a future occasion they will also receive 100,000 shares, the value of which will reflect the market price when they receive the shares three or four years hence.

In this context, assuming in four years the company’s share price is $15, the market would anticipate (if all performance considerations were met) that the executive would receive $1,500,000 in incentive value and not $2,850,200 through the allocation of 190,000 rights to shares.

This example highlights how using derivatives of accounting methodologies to allocate securities does so at a substantial discount to the prevailing share price. These rights are valued similarly to how a punter might calculate the value of a share he won’t get his hands on for four years, and then only if the company does certain things. The difference is that the punter is paying for the right to that share. The executive is not.

Today, widely different allocation practices are used in the marketplace, that is:

  1. The allocation of share rights on the basis of the prevailing share price.
  2. The allocation of share rights on the basis of a simple Black-Scholes calculation or Monte Carlo simulation.
  3. The above with the value being further adjusted for expected dividends over the performance period.

We note that in the last one or two years a number of companies have on advice shifted their allocation policy from a VWAP to either a Black-Scholes value or modified fair value using the methodologies defined above but have not changed in their disclosures the annual value of the LTI award being offered to executives.

We acknowledge that at the time an award is granted, a future remuneration benefit is offered. At the time that auditors and others were strongly pursuing the creation of a future remuneration value and amortisation of that value over the performance period, Egan Associates favoured the approach – it was seen as appropriate both from a governance and moral standpoint. In our opinion, the application of accounting standards is still perfectly appropriate for expensing the value of this future remuneration award opportunity to the P & L. 

The governance question which we believe is arising from variable practices and disclosures is whether the current approach of using these valuation methods for the allocation of equity retains the governance and moral fortitude of the intent of expensing LTI awards to the P & L account.

We raise this issue of valuation primarily in relation to a share right not an option, as there is no value in an option other than the share price appreciation and the market and shareholders alike have accepted Black-Scholes or a derivative of it as an appropriate approach for valuing such instruments for the purpose of both allocation and expensing to the P & L account. 

These challenges are complex.  We believe, however, it is beholden on Boards and their advisors to debate and discuss the ramifications of emerging practices and their appropriateness using both a moral compass and an awareness of competitor activity. Only then can they exercise their judgement in relation to what constitutes fair and reasonable reward given management’s accomplishments.

It’s unlikely that the issue will be fully explored until a majority of companies are using mark to market remuneration disclosure (valuing assets by the market price). 

Some companies are already disclosing the actual value of equity vesting in the year, and more would be forced on this issue if the legislation and regulations proposed at the end of 2012 were ever passed. However, given multiple concerns with the legislation (some of which are ours) it is likely to see serious amendments if it ever passes parliament. 

This disclosure would help savvy investors to notice when an executive receives amounts above the remuneration intent. For example, they might recall that an executive was granted $1 million worth of securities, which with gang-busting performance might have increased to $2.5 million at the end of the performance period. Then they see that due to the discounted allocation price, the larger number of shares is actually worth $6 million. They would wonder how that happened, given the return is so much higher than they themselves would have experienced for the same outlay. 

My judgment is this will become an issue that has to be openly addressed and fully explained in the context of the remuneration intent, which is an opportunity to earn an incentive for superior performance over a three-, four- or five-year period. Investors will ask themselves ‘in what way is the use of these accounting standards and valuation techniques aligned with that intent and the interest of shareholders?’  A modifier would be to limit the vested value of securities to the total shareholder return over the period on vested securities in relation to the original disclosed incentive value.

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