EXECUTIVE PAY
New approach to valuing long-term incentives
Watson Wyatt has developed a new methodology for measuring the "present economic value" of share option schemes to "help to ensure executive rewards and incentives are truly competitive and motivational yet not excessive".
Many companies now feel that, in certain market conditions, it is appropriate to award senior executives a combination of share options, and/or performance shares/restricted shares. So, it has become vital that businesses can calculate the relative "value" of each, to determine, for example, how many shares under option are equivalent to a performance share award.
The Present Economic Value methodology
Watson Wyatt’s new methodology can be used to determine the value of grant/award levels and compare a variety of share option and other long-term incentive plans (as part of a "portfolio" approach to share incentives). The consulting firm has called this approach "Present Economic Value" or PEV.
A range of assumptions covering, for example, early exercise, dividends, performance measures and future volatility are used to derive PEV values - which reflect currently volatile market conditions and executives' perception of the "real" value of share incentives.
| Drawbacks of Black-Scholes |
| The Watson Wyatt methodology builds on the Black-Scholes methodology, which is a widely accepted method of valuing share options, particularly in the USA. However, Watson Wyatt reckons that in an executive pay context Black-Scholes is insufficient in a number of ways:
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A final word
"PEV provides a business-based framework for institutional shareholders and corporate management to appreciate/understand share incentive award/grant levels, and how best to determine the level of these to minimise equity dilution and also incentivise/reward behaviour which promotes longer-term business success. Additionally, it assists companies in formulating hedging strategies for minimising their exposure from incentive plan liabilities. It also provides a framework for companies to understand risk from share incentives and allows them to trade-off this risk against expected gains in performance." - Richard Cockman, partner, Watson Wyatt.
Want to know more?
For more information contact Joanne Campbell at Watson Wyatt, tel: 01737 273387 or email: joanne.campbell@eu.watsonwyatt.com.
To read an article summarising the Watson Wyatt approach - "Pay the boss and keep the peace", by Richard Cockman, The Guardian, 23 February 2002 . . .
www.guardian.co.uk/Archive/Article/0,4273,4361692,00.html