1. Has Share-Based Compensation
Entered the “New Normal” Too?
Cory J. Thompson, CFA – cthompson@srr.com
Jason M. Muraco, CFA – jmuraco@srr.com
Andrew J. Robinson – arobinson@srr.com
the Great Recession caused many finance professionals to of share-based payment awards granted. We also investigated
reexamine their views of risk and return, and even led some the valuation methods and inputs reporting entities disclosed
prominent investors to declare a “new normal,” which is generally with respect to the fair value measurement of share-based
characterized as a period of low growth and low returns. the new compensation. the current data (compiled in october 2010) was
normal has broader applicability as well. Many argue that much then compared to the data compiled in November 2006 in order
like the Great Depression, the financial crisis of 2008 and 2009 led to analyze trends and changes that may have occurred over this
to a paradigm shift in the way average Americans lead their lives. volatile time period.1
It is within this spirit of reexamination and the new normal our recent review of share-based compensation practices
that we analyze the trends in current practices in share-based confirmed a number of our expectations following the review
compensation. In our valuation practice, we encountered with performed in 2006, and introduced several new observations.
increasing frequency over the course of 2010 reporting entities the results indicate that the new normal applies to share-based
that required assistance in the measurement of complex share- compensation. our findings illustrate that share-based payment
based payment awards. these awards were not the plain vanilla awards have become a larger component of total employee
time-based vesting stock options of the past, but rather grants of compensation. Moreover, while stock options are still the most
performance awards (e.g., restricted stock or stock options with widely used form of share-based compensation, there is an
performance and market condition vesting requirements). increasing trend for companies to issue restricted stock and/
or performance units with performance-based vesting criteria.
the goal of this article is to investigate whether the new normal We also found that companies have only slightly migrated from
has permeated share-based compensation practices. the employing closed-form models, such as the Black-Scholes option
specific analytics performed and discussed herein are largely Pricing Model (“BSoPM”), to more flexible techniques, such as
a refresh and extension of an article published by Stout Risius lattice models and Monte Carlo simulations, when measuring the
Ross, Inc. (SRR) in the Spring of 2007 (Trends In SFAS 123(R): Is fair value of traditional employee stock options. the following
the Black-Scholes Model Still King?). narrative details the observed themes.
to this end, we reviewed public filings for each component
corporation of the S&P 500® Index in order to analyze the variety
1
It should be noted that adjustments were not made to hold the sample companies
constant. As such, there may be an element of measurement error related to any
reshuffling of the S&P 500® Index between our research dates.
©2011 1

2. Median Share-Based Compensation Expense Ratios
5.0% 0.7%
4.5%
0.6%
4.0%
3.5% 0.5%
3.0% 0.4%
2.5%
0.3%
2.0%
1.5% 0.2%
1.0%
0.1%
0.5%
0.0% 0.0%
2005 2006 2007 2008 2009 2010 2005 2006 2007 2008 2009 2010
Share-Based Comp. as a Percentage of S,G&A Expense Share-Based Compensation as a Percentage of Total Revenue
Source: SRR analysis of share-based compensation for companies in the S&P 500® Index. Based on data as available from Capital IQ, Inc.
employee Share-Based Share-Based Compensation Expense as a Percentage of Revenue
Compensation expense on
the Rise n n n 3.0%
2.5%
Based on our analytical review and as
2.0%
illustrated in the above charts, share-
based compensation expense increased 1.5%
as a percentage of both selling, general, 1.0%
and administrative (“S,G&A”) expense
0.5%
and total revenue over the past six
0.0%
years. the historical increase is not a
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Accounting Standards Board Accounting 2005 2010 Source: SRR analysis of share-based compensation for companies in the S&P 500® Index.
Based on company and industry data as available from Capital IQ, Inc.
Standards Codification topic 718,
Compensation – Stock Compensation
tended to exhibit much less share-based compensation expense
(“FASB ASC 718”)), which requires reporting entities to
as a percentage of revenue.
measure the cost of employee services received in exchange
for an award of equity instruments based on the grant-date What we did find interesting, however, was the flattening trend
fair value of the award (with limited exceptions). Accordingly, of share-based compensation expense over the past four years,
FASB ASC 718 requires all public companies to record share- particularly given the varying economic cycles experienced and
based compensation expense on their income statement the volatility in corporate revenue, expenses, and earnings over
(and a balance sheet liability if settled in cash). Intuitively, the this time period. the trend suggests that companies within
trend makes sense, particularly as share-based awards are the S&P 500® Index may have “peaked” in regard to their
increasingly employed to align management compensation with utilization of share-based compensation packages within their
shareholder interests. organizations. on the other hand, the flattening trend may simply
be attributable to companies successfully adjusting or modifying
Additionally, when we examined share-based compensation
existing and new share-based payment awards in an effort to
practices by industry classification, we were not surprised to find
combat rising expenses.
that the information technology industry is by far the biggest user.
the data also indicates that financials and healthcare companies the later theory appears to have some support in the underlying
employ share-based payment awards more so than others (and, data from the S&P 500® Index companies. Specifically, the average
along with information technology, significantly increased using contractual term of employee stock option awards (still the most
share-based compensation over the observation period), while popular award granted within the S&P 500® Index) declined
companies in sectors such as utilities and consumer staples have
2 ©2011

3. between 2006 and 20102 from 9.59 years to 9.48 years. Most of
the companies within the S&P 500® Index issued stock options Analysis of Forms of Share-Based Compensation
with 10-year contractual terms, but a number of companies have 97% 98%
100%
decreased the term of their options in recent reporting periods.3 89%
90%
Additionally, the ratio of effective term to contractual term has 80%
increased from 54% to 57% between the two study dates. All else 70%
63%
held constant, a decline in the contractual term results in a lower 60%
option value (and thus lower compensation expense). However, 50%
this is mitigated by the fact that a decline in the contractual term 40% 37%
often results in a lower effective term for the options, which reduces 30%
30% 27%
value and the time frame over which the options are expensed. the 20%
20%
latter consideration appears to be less applicable however given
10%
the upward trend in the effective term to contractual term ratio.
0%
Stock Options Restricted Performance Other
Another way companies can combat rising share-based Stock/Units Shares/Units Share-Based
2006 2010 Payments
compensation expense is to shift from the issuance of time- Source: Review of the companies included in the S&P 500® Index as of the 2006 and 2010 study dates.
based vesting awards to performance-based vesting awards.
Compensation expense related to performance-based vesting
Given the continued shift in the type of award grants within
awards is adjusted for the probability that the performance metrics
organizations from simple, time-based stock options to more
will be met, while time-based vesting awards do not require any
complex, performance- and market-based awards, one may
probability adjustments, and therefore, typically result in greater
expect a shift in the general valuation methodologies utilized by
compensation expense all else held constant. As discussed in the
companies within the S&P 500® Index. Share-based payment
following section of this article, there has been a trend towards
award valuation methodology observations are discussed in the
the issuance of performance- and market- based vesting awards
following section.
relative to time-based vesting awards within the S&P 500® Index.
Flexible Valuation Methods Becoming
Continued Shift in type of Increasingly Important n n n
Awards Granted n n n
In our recent review, there was a slight decrease in the relative use
Companies continue to shift away from solely issuing stock
of BSoPM to measure the fair value of traditional employee stock
options, and instead are utilizing other share-based compensation
options (i.e., 85% to 83%). the decline coincides with an increase
awards that have either a time-, market-, or performance-based
in companies utilizing other techniques, such as lattice (e.g.,
vesting criterion (e.g., restricted stock and restricted stock units).4
binomial) models or Monte Carlo simulations. In fact, a number
Specifically, the number of companies that indicated an issuance
of companies within the S&P 500® Index commented within their
of restricted stock increased from 63% to 89% from our 2006 to
disclosures that the lattice model was a more flexible option than
2010 study. Further, the number of companies that indicated an
BSoPM in valuing employee stock options. Accordingly, many
issuance of performance awards increased from 20% to 37%
companies switched from BSoPM to a lattice model at some point
between the two study dates. Please refer to the following chart,
between the 2006 and 2010 study dates.5
which illustrates the relative use of the varying types of share-
based compensation awards. the decline in the use of BSoPM to estimate the fair value of
employee stock options is consistent with our expectations
overall, nearly all of the companies within the S&P 500® Index
following our 2006 review. However, the extent of the decline
with sufficient disclosure information (i.e., 96%) issued an award
is somewhat surprising given the fact that BSoPM is inflexible
other than traditional stock options in their most recent fiscal year.
with respect to factoring in suboptimal exercise behavior or any
this percentage compares to 76% as of our 2006 review. this
changes to the inputs (e.g., volatility or dividend yield). In fact, the
is evidence of the fact that companies continue to take steps to
only way to modify BSoPM to account for early exercise behavior
address the principal-agent problem within their organizations
is to adjust the effective term assumption.6 Moreover, BSoPM is
and are proactively aligning management compensation with
not equipped to accommodate changing volatility or dividend yield
shareholder interests.
inputs over the effective term of stock options.
2
Throughout this article, results for 2010 are based on the most recent fiscal year end statements available as of the 2010 study date (i.e., the most recent 10K filings). Results for the
previous years represent data from fiscal year end statements issued in sequential periods prior to the most recent data (e.g., 2008 represents data from the fiscal year end period that
was two years prior to the 2010 data). This methodology was used to avoid double counting the data.
3
Companies that decreased stock option terms between the 2006 and 2010 study dates include, but are not limited to, Alcoa, Inc.; AmerisourceBergen Corporation; Bed Bath & Beyond,
Inc.; Hewlett-Packard Company; SUPERVALU Inc.; Symantec Corporation; and Wellpoint, Inc.
4
Examples of such companies include Apple, Inc, which discontinued issuing stock options to employees and instead issues restricted stock units, and International Business Machines
Corp., which began issuing restricted stock units and performance stock units in lieu of stock options in 2007.
5
These companies include, but are not limited to, Best Buy Co., Inc.; Automatic Data Processing, Inc.; CarMax, Inc.; Staples, Inc.; Comerica, Inc.; and Corning, Inc.
©2011 3

4. performance of the underlying company’s stock price relative
Stock Options Valuation Method to the tSR of a peer group or market index. In fact, nearly 20%
of the companies within the S&P 500® Index that indicated the
100%
use of performance-based criteria compared their relative
90% 85% 83% performance to that of a peer group or other market benchmark.
80%
of these companies that reported disclosure, 43% utilized a
70% Monte Carlo simulation model in their estimation of share-based
60% compensation expense.
50%
40%
Conclusion n n n
30% the increasing trend of compensating employees with share-based
20% 14% 15% payments is designed to more closely align the long-term financial
10% interests of company management with those of its shareholders.
1% 2%
0% In a similar vein, companies are gradually moving from issuing
Black-Scholes Binomial/Lattice Monte Carlo
share-based payments in the form of stock options to restricted
2006 2010
Source: Review of the companies included in the S&P 500® Index as of the 2006 and 2010 study dates.
stock or performance awards with vesting contingent upon
either company-specific, market, or relative market performance.
Performance criteria often require the company (or its valuation
the issuance of the Securities and exchange Commission (“SeC”)
advisors) to use a more complicated valuation model (such as a
Staff Accounting Bulletin No. 110 (“SAB 110”) in December 2007
Monte Carlo simulation model as opposed to BSoPM) in order to
may be somewhat responsible for the continued reliance on
appropriately measure the fair value and derive the service period
BSoPM. SAB 110 affirmed that the SeC will continue to accept the
(i.e., the term over which the awards are expensed) of the share-
“simplified method” (introduced in 2005) to calculate the expected
based payment awards.
term assumption for stock options. the simplified method formula
(presented below) is an attempt to account for suboptimal exercise In the future, we would expect to witness the continued migration
behavior in the estimation of fair value. from the use of BSoPM to more flexible models as share-based
compensation becomes (i) less dependent on time metrics and
Expected Term = [(Vesting Term + Contractual Term) / 2]
more dependent on performance criteria and (ii) increasingly
Prior to the issuance of SAB 110, the SeC stated that it would material to reporting entities’ financial statements. Additionally,
not expect companies to utilize the simplified method beyond while we do not expect companies to abandon the use of
December 2007 since the expectation was that reporting stock options (given their straightforward nature and ease of
entities would be able to rely upon historical exercise behavior measurement), we would expect companies to increasingly employ
observations instead. SAB 110 “softened” this expectation with awards with performance- or market-based vesting conditions as
the comment that the SeC staff understands that such detailed companies balance pay and performance with the magnitude of
information about employee exercise behavior may not be widely compensation expense.
available by December 2007.
Cory J. thompson, CFA is a Managing Director in the Valuation
Despite the continued reliance on BSoPM for traditional employee & Financial opinions Group at Stout Risius Ross (SRR). He is well
stock options, our recent review of the S&P 500 Index did indicate ® versed in FASB ASC topics regarding business combinations,
a material increase in the utilization of Monte Carlo simulations for impairment testing, share-based payment awards, and fair value
complex vesting awards. Specifically, over 10% of the companies measurements and he has experience with the expectations of
within the index reported the use of a Monte Carlo simulation model financial reporting advisors and regulators. Mr. thompson can be
to value some portion of share-based compensation expense. this reached at +1.248.432.1319 or cthompson@srr.com.
trend is tied to the fact that companies continue to issue more
Jason M. Muraco, CFA, is a Director in the Valuation & Financial
complex share-based payment awards (e.g., performance-based
opinions Group at Stout Risius Ross (SRR). His valuation experience
awards), whereby simplified valuation methods may not accurately
includes solvency opinions, purchase price allocations, impairment
reflect the true economic value of the compensation expense.
testing, equity compensation, going-private transactions, transfer
An increasingly common example of such an award is a total pricing, and blockage opinions. Mr. Muraco can be reached at
shareholder return (“tSR”) award, whereby the final payout of +1.216.373.2989 or jmuraco@srr.com.
an award (e.g., restricted stock or cash) is based on the future
6
It should be noted that companies are beginning to use Monte Carlo simulation models to estimate the effective term of employee stock options. These companies include, but are not
limited to, Honeywell International, Inc. and Weyerhaeuser Co.
4 ©2011