Present Economic Value (PEV)
Companies are increasingly looking to improve the design of long-term incentives offered to executives to ensure that the interests of shareholders and executives are aligned. Following the recent volatility in capital markets, the changing attitudes of employers and employees to share incentive arrangements and revised perceptions of grant/award values, there is a need for a method of accurately valuing all types of long-term incentive on a consistent basis.
At the same time, the Association of British Insurers (ABI) and other institutional investors are taking an increasingly flexible approach towards share options and other long-term incentive arrangements, and the International Accounting Standards Board (IASB) has issued an accounting standard for share plans IFRS2. While these additional steps are welcomed, these changes have produced a new set of challenges:
- Many companies now believe that it is appropriate to reward senior executives with a combination of share options and/or performance shares/restricted shares.
- Companies therefore need to calculate the relative ‘value’ of each, to determine, for example, the appropriate mix of shares under option and performance shares.
- In cases where competitors operate different types of plan, with different performance conditions, how is it possible to gauge a particular company’s award levels against ‘the market’? The old multiple of salary method of comparing share options is clearly insufficient, particularly where awards have different performance conditions governing the release of options.
- The ABI allows larger grants where the ‘expected value’ of an award is lower, but provides limited guidance as to how this should be evaluated.
- The introduction of IFRS2 means that finance departments need to be more involved with share plan design than has been the case in the past.
How can PEV help?
PEV is a robust methodology developed by Watson Wyatt to value long-term incentive awards over the past five years. It determines a consistent and realistic present value for different types of long-term incentive, including share options, performance shares and restricted shares. It is the only such methodology which has been subject to a detailed paper presented at the Institute of Actuaries.
PEV provides a business-based framework for institutional shareholders and corporate management to consider share-based incentive award levels and how best to determine them, to minimise equity dilution whilst rewarding behaviour that promotes longer-term business success.
PEV can assist companies in determining appropriate funding strategies to minimise their exposure to the risks associated with incentive plan liabilities, including employer National Insurance contributions.
PEV can help you determine:
- What type(s) of share incentive vehicle is most appropriate for you
- The size of share incentive awards/grants and what the balance should be between the various types of share arrangements (for example, performance and restricted shares and share options)
- How various performance conditions influence the gearing of the expected gain
- The most appropriate funding strategy to meet the liabilities as they fall due.
- The implications of the new accounting requirements for share plan design.
How does PEV work?
PEV builds on existing models such as the Black-Scholes formula and the Binonial Lattice approach, but adapts these to take account of the distinctive features of executive incentive plans, including:
- Performance conditions – both ‘market related’ and ‘non market related’
- Early exercise, forfeiture and vesting conditions
- Term dependent volatility and dividend yield.
Why PEV
Choose Watson Wyatt’s PEV and you’ll benefit from the combined skills and experience of our world class actuaries, our executive compensation experts and our specialist communication consultants. We can help you to value your range of different long-term incentives consistently and accurately as well as work with you to communicate incentive awards/grants to institutional shareholders and executives.
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