Incentive plans: Why share price volatility matters

Estimated reading time: 4 minutes

Volatility is a particularly subjective assumption which can have a significant impact on the value placed on share-based awards – affecting both the design and accounting value of the awards.

Values placed on awards under long-term incentive plans and other share-based payments are typically calculated using option pricing models which take into account expected future movements in the company share prices.

A number of option pricing models exist including the Black-Scholes-Merton model, the binomial tree, and stochastic or Monte Carlo simulation models. In each model one of the most significant assumptions is the expected share price volatility.

Expected share price volatility - what is it and how does it affect the valuation?

Expected volatility is a measure of the extent to which the share price is expected to fluctuate during a period. In more technical terms, the measure of volatility used in option pricing models is the annualised standard deviation of the continuously compounded rates of return on the share over a period of time.

The chart below shows how the share price (assumed to be 100p now) might be expected to fluctuate over a one year period if expected annual volatility is 30% compared with 50%, using an example model.

Using the above example, if vesting of the awards is subject to a performance condition of the share price reaching a threshold of 180p, then vesting is clearly much more likely to happen if volatility is 50% rather than 30%.  The higher volatility assumption will increase the value of the awards for two reasons:

1. With 50% volatility, the share price will exceed the threshold in more stochastic simulations resulting in a higher likelihood of the awards vesting.
2. In those simulations where the awards vest, higher share prices are more likely with 50% volatility, resulting in a higher payout.

A fairly typical (but more complicated) performance measure might assess the total shareholder return (“TSR”) relative to a comparator group (such as the constituents of the FTSE250 Index).  For example, 25% of the award might vest only if the stock beats the Median of the comparator group, while 100% might vest if the stock beats the Upper Quartile, with interpolation applying in between.  In this case the pricing model could also include assumptions for the volatility of the constituents of the comparator group (and potentially correlations between different stocks).

The impact of the volatility assumption can depend on the structure of the particular award.  Generally speaking, the higher the volatility assumption, the higher the value of the awards.

Why are awards valued?

When designing and granting awards, the company should be modelling the value of those awards to better understand what they are offering.

A key consideration is the level at which performance conditions are to be set.  Under a good incentive plan, the performance target should be realistically attainable with stretched efforts in order to increase motivation.  A company with low expected share price volatility might set the performance targets at a lower level so that they remain achievable.

A lower volatility assumption might also mean that more awards could be granted at the same projected cost.

Accounting standards (IFRS 2 and Section 26 of FRS 102) require awards to be valued at the date of grant.  This value, known as the ‘fair value’, determines the reserve held on the company balance sheet and the expense amounts to be recognised in the profit and loss account over the vesting period of the awards.  The ultimate cost will usually depend on the level at which performance targets are set, the share price at exercise and whether the vesting conditions are met.

Factors to consider when setting the volatility assumption

The accounting standards state that the volatility assumption should reflect current expectations about future volatility and aim to approximate the expectations that would be reflected in a current market or the negotiated exchange price for the option.

However volatility is a particularly subjective assumption and there is often likely to be a range of reasonable expectations about future volatility.

Factors to consider when estimating expected volatility of the share price include:

1. Implied volatility from traded options/instruments of a comparable term, if any.
2. Historical volatility of the share price over the most recent period.
3. The tendency of volatility to revert to its long-term mean i.e. consideration of longer periods.
4. Any factors indicating that expected future volatility might differ from past volatility.  For example, a period of extreme volatility caused by a specific event such as a failed takeover bid could reasonably be disregarded from the volatility analysis.
5. For newly listed or unlisted entities, the historical volatility of similar listed entities in the same industry.