Performance shares are the shares given to top management of company as a reward for reaching performance criteria, e.g. earnings, market share. Examples of many companies have shown that managers are more interested in company results if they own part of it. Therefore, performance shares should motivate managers to reach higher results.They are recognized as an additional benefit while the company is performing well or better that it was assumed. In most of the cases they are issued while some specific regulations are met (for example performance target, sales, earning for shares, EBIT, ROE, EPS). They are issue at the end of performance period. The expanse is adjusted to equal the value of the shares that actually vest. Performance shares are determined by stock market performance (for example stock price change or TSR). They are mostly valued with the use of lattice model or Monte Carlo simulation .
There are many examples showing that wrong set of targets for managers associated with performance shares can lead to better short time results, but then lead into decline or even crisis. Some managers try to reach targets quickly, at a cost of sustainable growth, obtain their shares, sell them and then leave company before the crisis occurs.
Therefore, it is very important to set proper targets, not only short time, but also long time ones.
In finance lattice model is recognized as a technique applied to the valuation of derivatives, where a discrete time model is required. Such structure employs a binomial tree in order to show different paths the price of the underlying asset may take over the derivative's life. It means that each variable may change many times over different time periods during the life of the option (it doesn’t remain constant). A lattice formula can change:
- the dividend rate each quarter/year based on future dividend policy
- the risk-free interest rate over the time if rates are expected to change
- the volatility for company specific factors that will cause it to change
- the expected exercise behavior of the employees based on a host of variables such as their employment termination rate
Monte Carlo simulation
Monte Carlo simulation is a technique used to see the impact of risk and unreliability in financial, project management, cost, and other forecasting models. A Monte Carlo simulator helps to visualize most or all of the potential outcomes to have a better idea regarding the risk of a decision. Monte Carlo simulation conducts risk analysis with a use of building models of possible results by involving a range of values—a probability distribution—for any component that has inherent uncertainty. Then it calculates results each time using a different set of random values from the probability functions .
Regarding to normal federal tax rules, an employee receiving a performance award is not taxed at the time of the grant. However, the employee is taxed at vesting, unless the plan allows for the employee to defer receipt of the cash or shares.
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Author: Weronika Włodarska