What Are TSRs and How Do We Value Them?

Investors buzz about corporate governance, specifically, in the context of executive compensation.  A handful of buzzwords underscore the push for appropriate incentive plans for corporate executives.  The prevalence of catchphrases such as “pay for performance,” “shareholder alignment,” “say on pay,” and “long-term incentives” seems to correspond with the number of performance awards that we have seen lately.


In general, executive compensation can be paid in three ways: cash, restricted stock, and stock options.  Performance shares are a form of restricted stock with a variable twist; the grant depends on a company’s actual performance over a predetermined time period.  Contingent share units are granted at the beginning of a performance period, typically lasting three to five years.  The grantee / executive receives the equity interest without any required investment, while the grantor / company recognizes a compensation cost, under ASC Topic 718.

Performance shares provide executives with rewards for meeting specific long-term performance targets.  At the end of a designated performance period, the grantee / executive earns a portion of (or multiple of) the contingent shares originally granted, depending on the extent to which the subject company’s performance targets are met.  Awards may be paid in cash or stock.  The payment is taxed as ordinary income and the grantor / company receives a tax deduction equal to the amount of the payments. The grantor / company charges the value of performance shares as earnings to reflect the value of the shares at the end of the performance period.[1]

Relative Total Shareholder Return (“TSR”) programs represent one common form of performance shares (also known as full value plans).  They measure a subject company’s performance relative to a group of its peers.  TSRs represent equity awards, which differ from liability awards.  Equity awards are settled in shares and generally valued at the date of grant.  There is only one valuation per grant.  Liability awards, on the other hand, are generally settled in cash and are re-measured at each reporting date until they are settled.

Equity Instruments

Liability Instruments

Stock Options

Cash Settled SARs

Stock Settled SARS

Cash Settled RSUs

Restricted Stock

Performance Cash

Stock Settled RSUs

Performance Shares


The trick for determining the value of a TSR grant involves a Monte Carlo (simulation) analysis.  David Dufendach and Jason Andrews (with introduction by Neil Beaton) authored an extremely helpful book: “Monte Carlo Simulations: Advanced Techniques.”  In this text, Dufendach and Andrews describe numerous ways to utilize simulation in business valuation.  The publication’s electronic form, available at Business Valuation Resources, includes several Excel files.  I have found these particular files to be very helpful, especially in valuing TSRs.

Attributing value to TSR performance shares generally involves evaluating the expected number of shares granted, based on the subject company’s total shareholder return rank relative to a group of pre-selected peer companies. Total shareholder return is measured by a performance goal or target provision set forth in the subject company’s incentive plan agreement.  Depending on the TSR target provision, we attempt to model the probability of the subject company achieving the relevant milestone event, relative to its peers.  For example, where the relevant performance goal is measured by a calculation of expected return on the subject company’s share price (as compared with the comparable peer companies), we would run a forecast of returns, based on the subject company’s share price, and run the same analysis for all of the pre-selected peer companies.

In order to forecast the uncertainty around calculating expected returns based on projected share price, we run an iterative simulation model.  This model solves for the subject company’s projected share price, along with each of the peer companies.  In the valuation of performance units with total shareholder return requirements, the typical key inputs necessary to derive fair value are: the volatility of the subject company (as well as the comparable companies, or index), the respective dividend yields, and the market correlation.

We utilize a Monte Carlo simulation technique to estimate the forecasted target performance goal for the subject company and its peer companies.  A Monte Carlo analysis satisfies the need for a simulation of specified future outcomes, based on algorithms that rely on repeated random sampling (Stochastic process using Geometric Brownian Motion).  Through this analysis, the outcome of a specific unknown quantity (i.e., the fair value of future performance unit grants) is determined based on random variation, within a given probability distribution, in certain specified underlying variables.

The assumptions behind each of the variables simulated are described below.

  • Volatility: We estimate the volatility of expected stock prices for the company, and each of the peer companies, based upon observed historical volatility.
  • Dividend Yield: The second key input is dividend yield. We generally base our dividend yield assumptions for the Company and each of the peer companies by evaluating actual dividends paid over a designated historical period.
  • Term: The term of the performance period is generally spelled out in the incentive plan agreement.  However, it is worth noting that if the grant date occurs after the start of the performance period, the analyst should consider all information known or knowable as of the valuation date.
  • Correlation Coefficient: The final key input in the analysis is the correlation coefficient of the individual companies to a common index.  A correlation coefficient is a measure of the degree to which one security moves in sync with another.


We had a recent case for a public company that involved the following fact-pattern.  The number of shares awarded to each grantee was based on the subject company’s attainment of performance goals, calculated on the basis of expected returns derived from each company’s (the subject company and its public peers) publicly-traded equity securities.  The basis of expected returns was measured by the average share price for the last 20 days of a projected three-year performance period over the average share price for the 20 days preceding the three-year performance period.



A = the average Share Price for the twenty (20) trading days preceding the beginning of the Performance Period;

B = ordinary dividends (cash or stock based on ex-dividend date) paid per share of common stock over the Performance Period;

C = the average Share Price for the last twenty (20) trading days of the Performance Period.

The number of shares awarded to each grantee resulted from ranking the subject company’s TSR as compared with the peer companies.  The subject company based its grant of performance shares on its relative TSR percentile rank, as follows:

  • If the subject company is ranked first among its peers, 200{7656ca219931958fe15db644f5e70e9855a8d6dc7ecf752fd1b70e2be3385646} of the target performance shares;
  • If the subject company is ranked at or above the 75th percentile of the peer companies, including the subject company, 150{7656ca219931958fe15db644f5e70e9855a8d6dc7ecf752fd1b70e2be3385646} of the target performance shares;
  • If the subject company is ranked at or above the 50th percentile or median of the peer companies, including the subject company, 100{7656ca219931958fe15db644f5e70e9855a8d6dc7ecf752fd1b70e2be3385646} of the target performance shares;
  • If the subject company is ranked at or above the 25th percentile of the peer companies, including the subject company, 50{7656ca219931958fe15db644f5e70e9855a8d6dc7ecf752fd1b70e2be3385646} of the target performance shares; and
  • If the subject company is ranked below the 25th percentile of the peer companies, including the subject company, the award gets forfeited.


Over the years, the SEC has confronted the issue of executive compensation by adopting successively expanded disclosure requirements for the express purpose of providing a clearer presentation of senior executive compensation.[1]  Among the executive compensation disclosures required, under DODD-FRANK subsection (j) to Section 14 of the Exchange Act of 1934 requires a description of the relationship between actual executive compensation and the subject company’s financial performance (taking into account the change in value of the stock of the subject company and any dividends and distributions). This requirement underscores a preference for total shareholder return as a means for determining pay for performance. However, total shareholder return can lead to misleading results for a variety of reasons, including market forces outside the control of the subject company. Such a determinant also may penalize managers who operate an environment where controlling the losses may well be a substantial achievement.[2]

Detailed discussion is required with respect to the relationship of the chief executive officer’s compensation to the subject company’s financial performance.[3] The SEC requires a line graph plotting five years relationship between executive compensation and overall corporate performance.  To satisfy this requirement, overall corporate performance is measured using cumulative total shareholder return, which itself is contrasted with an acceptable stock index.  If you look at the proxy statements of public companies, you find the above-mentioned performance graph.  Every proxy must have a graph for at least the last five years, comparing the subject company to a specified peer group selected by the subject company.


Ideally, aligning executive compensation with shareholder interests diffuses some of the dangers associated with agency relationships.  Shareholders entrust management with funds.  Management serves to invest in capital goods, financial capital, and human capital.  The ultimate goal is developing a platform to maximize shareholder wealth.  Agency costs, both implicit and explicit, take a toll when managers do not act in the best interest of shareholders.  Performance shares may improve the situation, but the question remains whether they are a real solution.  Based on recent press, it appears that is not the case.

The Wall Street Journal recently published an article on companies that use per share earnings as their target metric for performance shares. [4]  The article found that companies that tie executive pay to per-share earnings are more likely to engage in stock buyback transactions.  This is because share buybacks improve earnings per share by reducing the total number of shares outstanding—the denominator in the earnings per share calculation.  In some cases, it appears companies had effected dividend recapitalizations with share buybacks by encumbering significant debt in order to finance the transaction.

[1] Modern Corporation Checklists Database Updated May 2013 Part G. Compensation and Tax Management Chapter 17. Compensation and Incentives

[2] Executive Compensation Disclosure, Securities Act Release No. 6962 [1992 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 85,056 (Oct. 16, 1992).

[3] Executive Compensation for Emerging Growth Companies, 3rd Edition Database updated July 2013

[4] Item 402(a)(4) and Item 402(k)(2) of Regulation S-K, 17 C.F.R. 229.402(a)(4) & (k)(2) (2009).

[5] “As Companies Step Up Buybacks, Executives Benefit, Too” Scott Thurm and Serena Ng. Wall Street Journal, May 5, 2013. <<http://online.wsj.com/article/SB10001424127887324582004578456623771366426.html?KEYWORDS=stock+buybacks>>

By |2013-12-19T17:15:46+00:00July 31st, 2013|Featured|Comments Off on What Are TSRs and How Do We Value Them?