Key takeaways:
Equity compensation — a form of non-cash payment to employees — has long been a cornerstone of attracting and retaining top talent. Incentivizing and rewarding employees by granting them ownership stakes in their company aligns employees’ interests with those of the shareholders insofar as the value of their equity compensation is directly tied to the company’s performance.
In the past, equity awards were issued in the form of stock options or restricted stock. Today, relative total shareholder return (rTSR) awards are one of the most prevalent forms of market-based compensation. In fact, according to a recent study by Equilar, more than 60% of S&P 500 companies use rTSR awards as part of their executive compensation programs.
An rTSR award is a type of performance-based equity compensation that ties the payout to the company’s stock performance relative to a predetermined peer group or index over a specified period.
It aligns the interests of employees with those of shareholders by incentivizing actions that drive long-term shareholder value. Many companies issue rTSR awards, particularly in industries where stock performance is a key metric of success. The appeal lies in rewarding executives based on how the company performs compared to its peers, rather than solely on absolute stock price performance.
rTSR awards align executive compensation with relative stock performance and encourage long-term shareholder value, while introducing complexity in valuation and reliance on peer-group selection.
Some of the pros of using rTSR awards as equity compensation include the following:
While rTSR awards have many benefits, there are downsides as well. They include the following:
Valuation of rTSR awards typically relies on Monte Carlo simulation to model relative stock price paths and capture leverage in payout structures, making fair value sensitive to volatility, correlation, and payout design.
One of the key challenges in implementing rTSR awards is determining their fair value. Unlike the value of traditional stock options or restricted stock, the fair value of rTSR awards could be significantly higher due to their performance-based nature and the use of market-based metrics. Specifically, the high fair value of an rTSR award is primarily due to the inherent leverage in the payout structure, which can result in payouts that are multiples of the target award value if the company’s stock significantly outperforms that of the peer group. Complex payout features can require approaches found in carried interest appraisals when modeling leveraged equity outcomes.
Because the vesting of rTSR awards are considered market-based vesting awards, which means that their vesting is contingent on the company’s stock performance relative to a peer group or index, their valuation requires the use of specialized valuation models such as Monte Carlo simulations. A Monte Carlo simulation can account for the uncertainty inherent in rTSR calculations and market conditions. Practitioners often draw on valuation methods for intangible assets when selecting model inputs for Monte Carlo simulations. It can model potential future stock price paths of both the subject company and the selected peer group or index, considering factors such as volatility, correlation, and dividend yields, which allows for a more reasonable calculation of the value of the award based on the award’s payout structure.
Monte Carlo simulation approaches are routinely accepted by auditors and regulators when supported by transparent assumptions, documented inputs, and reproducible model workflows.
Critical valuation inputs include grant date and measurement period, carefully selected peer groups, and the award’s payout structure, each of which materially influences expected payouts and fair value.
Grant Date and Measurement Period
The grant date is the date on which the rTSR award is granted to the employee, and the measurement period is the time frame over which the company’s stock performance is analyzed relative to that of the peer group or index.
Peer Group
The peer group (or an index) is a carefully selected group of companies whose stock performance is compared to that of the subject company. Selecting the peer group is a critical aspect of an rTSR award, as it can significantly impact the award’s payout and value.
Payout Structure
The payout structure defines the relationship between the company’s relative stock performance and the payout level. Common payout structures include linear payout curves, step functions, or capped payouts.
At the time an rTSR award is granted, a specific number of shares, commonly referred to as a “target,” is stated in the equity award agreement. Depending on the payout structure and the company’s performance compared to that of the peer group, an employee receives a certain percentage of those target shares. Those percentages typically range from 0% to 200%. The table below illustrates a payout based on the subject company’s performance compared to that of a peer group.
|
Percentile Ranking |
Percentage of Target Shares Earned |
|
25th and below |
0% |
|
50th (target) |
100% |
|
75th and above |
200% |
Using the example in the table above, if the subject company’s performance ranks above the 25th but below the 50th percentile, the target shares earned is determined using a linear calculation between the two percentiles. As you might expect, the higher the potential payout percentage of the rTSR award, the greater the fair value — but only to a certain point. If the upper threshold were increased from the 75th to the 90th percentile, the probability of exceeding that threshold is lower, as is the resulting fair value.
Once the peer group and payout structure of the rTSR award are determined, the fair value of the award must be determined for equity compensation purposes. As mentioned, the most commonly used valuation model is a Monte Carlo simulation. In addition to incorporating the specifics of the rTSR award, the model must include certain inputs or assumptions that will improve the accuracy of the simulation results. These inputs include the following:
Design variations and evolving terms in rTSR awards increase analytic complexity, which often leads firms to engage specialized valuation providers to produce defensible, audit-ready analyses.
As companies continue to refine their executive compensation programs, they may introduce new terms or variations to rTSR awards, both in design and payout, further increasing the complexity of valuing these awards. As a result, many companies choose to engage valuation firms with expertise in equity compensation to ensure accurate and defensible valuations of their rTSR awards, as well as to stay compliant with accounting and regulatory requirements.
PCE has a broad range of experience in providing fair value financial reporting and related services to businesses and organizations, including public and private companies, private equity firms, early-stage enterprises, and other closely held businesses and partnerships. Our professionals have in-depth knowledge and understanding of the reporting requirements and best practices in such valuations, and we provide a full range of fair value measurement services. Many clients engage business valuation services to produce defensible analyses for financial reporting and compliance. Our analyses and conclusions have been widely accepted, withstanding the scrutiny of auditors, the SEC, and other regulatory bodies.
With our team’s background in fair value accounting, we assist clients with valuation matters impacting their financial statements and help them navigate the nuanced financial and strategic issues. And because our firm understands fair value issues, local and national accounting firms regularly refer financial reporting valuation assignments to PCE Valuations.
If you’re thinking about using rTSR awards in your company or would like to know your existing awards have been valued correctly, contact us today. Engagement of valuation specialists with demonstrated experience in equity compensation valuation strengthens the defensibility and auditability of rTSR award valuations.
Q: What is an rTSR award and how does it function?
A: An rTSR award is a performance-based equity grant whose payout is determined by the company's total shareholder return relative to a predetermined peer group or index over a specified measurement period. Payouts are typically structured around percentile rankings versus peers and can range from zero to multiples of the target award.
Q: What are the main benefits of using rTSR awards?
A: rTSR awards align executive incentives with shareholder outcomes by tying compensation to relative market performance, provide clear benchmarking against industry peers, and encourage a long-term focus on sustainable value creation.
Q: What are the primary risks or downsides of rTSR awards?
A: Key risks include valuation complexity, sensitivity to peer-group selection and external market factors, potential for disproportionate windfalls, and challenges in communicating the structure and outcomes to stakeholders.
Q: How is the fair value of an rTSR award typically determined?
A: Fair value commonly relies on Monte Carlo simulation to model potential future stock price paths for the company and its peers, incorporating inputs such as the risk-free rate, volatility, correlation, dividend yields, and the award's payout formula to estimate expected payouts.
Q: What factors should be considered when valuing rTSR awards?
A: Valuation should consider the grant date and measurement period, peer group selection, payout structure (including caps and curves), and modelling inputs like volatility and correlation; documentation and specialist valuations are often necessary to support audit and regulatory scrutiny.
Paul Vogt
Paul Vogt is a managing director at PCE and leads the firm’s valuation. With over 20 years of experience, he specializes in valuations for financial reporting, tax compliance, and complex securities. Paul advises clients across various industries, including tech, healthcare, and manufacturing, ranging from intangible assets to equity-based compensation.
Valuation
pvogt@pcecompanies.com
Atlanta Office
407-621-2100 (main)
678-641-4760 (direct)
407-621-2199 (fax)