Cory J. Thompson, CFA – cthompson@srr.comJason M. Muraco, CFA – jmuraco@srr.comAndrew J. Robinson – arobinson@srr.com

©2011 1

Has Share-Based Compensation Entered the “New Normal” Too?

the Great Recession caused many finance professionals to

reexamine their views of risk and return, and even led some

prominent investors to declare a “new normal,” which is generally

characterized as a period of low growth and low returns. the new

normal has broader applicability as well. Many argue that much

like the Great Depression, the financial crisis of 2008 and 2009 led

to a paradigm shift in the way average Americans lead their lives.

It is within this spirit of reexamination and the new normal

that we analyze the trends in current practices in share-based

compensation. In our valuation practice, we encountered with

increasing frequency over the course of 2010 reporting entities

that required assistance in the measurement of complex share-

based payment awards. these awards were not the plain vanilla

time-based vesting stock options of the past, but rather grants of

performance awards (e.g., restricted stock or stock options with

performance and market condition vesting requirements).

the goal of this article is to investigate whether the new normal

has permeated share-based compensation practices. the

specific analytics performed and discussed herein are largely

a refresh and extension of an article published by Stout Risius

Ross, Inc. (SRR) in the Spring of 2007 (Trends In SFAS 123(R): Is the Black-Scholes Model Still King?).

to this end, we reviewed public filings for each component

corporation of the S&P 500® Index in order to analyze the variety

of share-based payment awards granted. We also investigated

the valuation methods and inputs reporting entities disclosed

with respect to the fair value measurement of share-based

compensation. the current data (compiled in october 2010) was

then compared to the data compiled in November 2006 in order

to analyze trends and changes that may have occurred over this

volatile time period.1

our recent review of share-based compensation practices

confirmed a number of our expectations following the review

performed in 2006, and introduced several new observations.

the results indicate that the new normal applies to share-based

compensation. our findings illustrate that share-based payment

awards have become a larger component of total employee

compensation. Moreover, while stock options are still the most

widely used form of share-based compensation, there is an

increasing trend for companies to issue restricted stock and/

or performance units with performance-based vesting criteria.

We also found that companies have only slightly migrated from

employing closed-form models, such as the Black-Scholes option

Pricing Model (“BSoPM”), to more flexible techniques, such as

lattice models and Monte Carlo simulations, when measuring the

fair value of traditional employee stock options. the following

narrative details the observed themes.

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.

©20112

employee Share-Based Compensation expense on the Rise n n n

Based on our analytical review and as

illustrated in the above charts, share-

based compensation expense increased

as a percentage of both selling, general,

and administrative (“S,G&A”) expense

and total revenue over the past six

years. the historical increase is not a

surprise given the release of Statement

of Financial Accounting Standards

No. 123 (revised 2004) (n/k/a Financial

Accounting Standards Board Accounting

Standards Codification topic 718,

Compensation – Stock Compensation

(“FASB ASC 718”)), which requires reporting entities to

measure the cost of employee services received in exchange

for an award of equity instruments based on the grant-date

fair value of the award (with limited exceptions). Accordingly,

FASB ASC 718 requires all public companies to record share-

based compensation expense on their income statement

(and a balance sheet liability if settled in cash). Intuitively, the

trend makes sense, particularly as share-based awards are

increasingly employed to align management compensation with

shareholder interests.

Additionally, when we examined share-based compensation

practices by industry classification, we were not surprised to find

that the information technology industry is by far the biggest user.

the data also indicates that financials and healthcare companies

employ share-based payment awards more so than others (and,

along with information technology, significantly increased using

share-based compensation over the observation period), while

companies in sectors such as utilities and consumer staples have

tended to exhibit much less share-based compensation expense

as a percentage of revenue.

What we did find interesting, however, was the flattening trend

of share-based compensation expense over the past four years,

particularly given the varying economic cycles experienced and

the volatility in corporate revenue, expenses, and earnings over

this time period. the trend suggests that companies within

the S&P 500® Index may have “peaked” in regard to their

utilization of share-based compensation packages within their

organizations. on the other hand, the flattening trend may simply

be attributable to companies successfully adjusting or modifying

existing and new share-based payment awards in an effort to

combat rising expenses.

the later theory appears to have some support in the underlying

data from the S&P 500® Index companies. Specifically, the average

contractual term of employee stock option awards (still the most

popular award granted within the S&P 500® Index) declined

Source: SRR analysis of share-based compensation for companies in the S&P 500® Index. Based on data as available from Capital IQ, Inc.

Median Share-Based Compensation Expense Ratios

Share-Based Comp. as a Percentage of S,G&A Expense Share-Based Compensation as a Percentage of Total Revenue

2005 2010

2005 2007 20072009 20092006 20062008 20082010 20102005

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5.0%

4.5%

4.0%

3.5%

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%

0.7%

0.6%

0.5%

0.4%

0.3%

0.2%

0.1%

0.0%

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%

Share-Based Compensation Expense as a Percentage of Revenue

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.

©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

with 10-year contractual terms, but a number of companies have

decreased the term of their options in recent reporting periods.3

Additionally, the ratio of effective term to contractual term has

increased from 54% to 57% between the two study dates. All else

held constant, a decline in the contractual term results in a lower

option value (and thus lower compensation expense). However,

this is mitigated by the fact that a decline in the contractual term

often results in a lower effective term for the options, which reduces

value and the time frame over which the options are expensed. the

latter consideration appears to be less applicable however given

the upward trend in the effective term to contractual term ratio.

Another way companies can combat rising share-based

compensation expense is to shift from the issuance of time-

based vesting awards to performance-based vesting awards.

Compensation expense related to performance-based vesting

awards is adjusted for the probability that the performance metrics

will be met, while time-based vesting awards do not require any

probability adjustments, and therefore, typically result in greater

compensation expense all else held constant. As discussed in the

following section of this article, there has been a trend towards

the issuance of performance- and market- based vesting awards

relative to time-based vesting awards within the S&P 500® Index.

Continued Shift in type of Awards Granted n n n

Companies continue to shift away from solely issuing stock

options, and instead are utilizing other share-based compensation

awards that have either a time-, market-, or performance-based

vesting criterion (e.g., restricted stock and restricted stock units).4

Specifically, the number of companies that indicated an issuance

of restricted stock increased from 63% to 89% from our 2006 to

2010 study. Further, the number of companies that indicated an

issuance of performance awards increased from 20% to 37%

between the two study dates. Please refer to the following chart,

which illustrates the relative use of the varying types of share-

based compensation awards.

overall, nearly all of the companies within the S&P 500® Index

with sufficient disclosure information (i.e., 96%) issued an award

other than traditional stock options in their most recent fiscal year.

this percentage compares to 76% as of our 2006 review. this

is evidence of the fact that companies continue to take steps to

address the principal-agent problem within their organizations

and are proactively aligning management compensation with

shareholder interests.

Given the continued shift in the type of award grants within

organizations from simple, time-based stock options to more

complex, performance- and market-based awards, one may

expect a shift in the general valuation methodologies utilized by

companies within the S&P 500® Index. Share-based payment

award valuation methodology observations are discussed in the

following section.

Flexible Valuation Methods Becoming Increasingly Important n n n

In our recent review, there was a slight decrease in the relative use

of BSoPM to measure the fair value of traditional employee stock

options (i.e., 85% to 83%). the decline coincides with an increase

in companies utilizing other techniques, such as lattice (e.g.,

binomial) models or Monte Carlo simulations. In fact, a number

of companies within the S&P 500® Index commented within their

disclosures that the lattice model was a more flexible option than

BSoPM in valuing employee stock options. Accordingly, many

companies switched from BSoPM to a lattice model at some point

between the 2006 and 2010 study dates.5

the decline in the use of BSoPM to estimate the fair value of

employee stock options is consistent with our expectations

following our 2006 review. However, the extent of the decline

is somewhat surprising given the fact that BSoPM is inflexible

with respect to factoring in suboptimal exercise behavior or any

changes to the inputs (e.g., volatility or dividend yield). In fact, the

only way to modify BSoPM to account for early exercise behavior

is to adjust the effective term assumption.6 Moreover, BSoPM is

not equipped to accommodate changing volatility or dividend yield

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.

Analysis of Forms of Share-Based Compensation

Source: Review of the companies included in the S&P 500® Index as of the 2006 and 2010 study dates.

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

2006 2010

Stock Options

97%

63%

20%

98%

89%

37%

27%30%

Restricted Stock/Units

Performance Shares/Units

Other Share-Based

Payments

©20114

the issuance of the Securities and exchange Commission (“SeC”)

Staff Accounting Bulletin No. 110 (“SAB 110”) in December 2007

may be somewhat responsible for the continued reliance on

BSoPM. SAB 110 affirmed that the SeC will continue to accept the

“simplified method” (introduced in 2005) to calculate the expected

term assumption for stock options. the simplified method formula

(presented below) is an attempt to account for suboptimal exercise

behavior in the estimation of fair value.

Expected Term = [(Vesting Term + Contractual Term) / 2]

Prior to the issuance of SAB 110, the SeC stated that it would

not expect companies to utilize the simplified method beyond

December 2007 since the expectation was that reporting

entities would be able to rely upon historical exercise behavior

observations instead. SAB 110 “softened” this expectation with

the comment that the SeC staff understands that such detailed

information about employee exercise behavior may not be widely

available by December 2007.

Despite the continued reliance on BSoPM for traditional employee

stock options, our recent review of the S&P 500® Index did indicate

a material increase in the utilization of Monte Carlo simulations for

complex vesting awards. Specifically, over 10% of the companies

within the index reported the use of a Monte Carlo simulation model

to value some portion of share-based compensation expense. this

trend is tied to the fact that companies continue to issue more

complex share-based payment awards (e.g., performance-based

awards), whereby simplified valuation methods may not accurately

reflect the true economic value of the compensation expense.

An increasingly common example of such an award is a total

shareholder return (“tSR”) award, whereby the final payout of

an award (e.g., restricted stock or cash) is based on the future

performance of the underlying company’s stock price relative

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

use of performance-based criteria compared their relative

performance to that of a peer group or other market benchmark.

of these companies that reported disclosure, 43% utilized a

Monte Carlo simulation model in their estimation of share-based

compensation expense.

Conclusion n n n

the increasing trend of compensating employees with share-based

payments is designed to more closely align the long-term financial

interests of company management with those of its shareholders.

In a similar vein, companies are gradually moving from issuing

share-based payments in the form of stock options to restricted

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

advisors) to use a more complicated valuation model (such as a

Monte Carlo simulation model as opposed to BSoPM) in order to

appropriately measure the fair value and derive the service period

(i.e., the term over which the awards are expensed) of the share-

based payment awards.

In the future, we would expect to witness the continued migration

from the use of BSoPM to more flexible models as share-based

compensation becomes (i) less dependent on time metrics and

more dependent on performance criteria and (ii) increasingly

material to reporting entities’ financial statements. Additionally,

while we do not expect companies to abandon the use of

stock options (given their straightforward nature and ease of

measurement), we would expect companies to increasingly employ

awards with performance- or market-based vesting conditions as

companies balance pay and performance with the magnitude of

compensation expense.

Cory J. thompson, CFA is a Managing Director in the Valuation

& Financial opinions Group at Stout Risius Ross (SRR). He is well

versed in FASB ASC topics regarding business combinations,

impairment testing, share-based payment awards, and fair value

measurements and he has experience with the expectations of

financial reporting advisors and regulators. Mr. thompson can be

reached at +1.248.432.1319 or cthompson@srr.com.

Jason M. Muraco, CFA, is a Director in the Valuation & Financial

opinions Group at Stout Risius Ross (SRR). His valuation experience

includes solvency opinions, purchase price allocations, impairment

testing, equity compensation, going-private transactions, transfer

pricing, and blockage opinions. Mr. Muraco can be reached at

+1.216.373.2989 or jmuraco@srr.com.

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.

Stock Options Valuation Method

Source: Review of the companies included in the S&P 500® Index as of the 2006 and 2010 study dates.

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

2006 2010

Black-Scholes Binomial/Lattice Monte Carlo

85%

15%14%

83%

2%1%