Valuing your non-qualified stock options is vital to formulating a proper equity compensation strategy. Understanding the components of stock option valuation can help you determine when and how to exercise and sell your stock options.
While incorporating equity compensation into a holistic financial plan can, and often does, call for an approach that might deviate from the optimal strategy from a valuation standpoint, it is always helpful in framing the decision making process.
Stock options are composed of two values, the intrinsic value and the time value. Although separate values, they are intertwined and impact each other.
The intrinsic value of an option is the difference between the current value of the stock and the exercise price of the option. It is the same figure commonly referred to as the spread or bargain element. Essentially, intrinsic value is the amount of profit you would have if you exercised the option now and sold the stock equal to its current value.
If the current value of the stock is below the exercise price of your option, you can avoid a loss by simply choosing not to exercise. Given this rational thinking, intrinsic value is never negative. When the value of the stock is equal to or less than the exercise price, the intrinsic value is zero.
The easiest way to grasp the time value of an option is to look at an option with a current intrinsic value of zero. Say you have an option with an exercise price of $100 and a current value of $100. In this instance the intrinsic value is zero. However, the option expires seven years from now. If I were to approach you with an opportunity to buy the option, you would realize that despite the current intrinsic value of zero, the option is far from worthless.
The option still has the potential to produce substantial profit for you, however, the profit is anything but guaranteed. The ability to hold the option for an additional seven years is the time value of the option. Time value is highly sought after by options traders in the market.
When helping clients grasp the real value of time value, I break it down into two distinct elements.
- If you continue to hold the option, you will pay the exercise price when you decide to exercise. That could be months or years from now. In effect, the option is providing an interest free loan of the exercise price!
- If you continue to hold the option, you are at risk of losing any intrinsic value currently available, but you won’t suffer any losses on price declines below the exercise price since you have the option of not exercising in that situation. However, once you exercise you are entirely exposed to a risk of loss that is far greater than the exercise price of your option.
Together, these two elements help highlight the power of leverage. Company stock options provide an extremely favorable asymmetry that is hard to come by anywhere else. Where else can you get (theoretically) unlimited profit potential with a floor that is set at the exercise price of the option, and an expiration date years into the future?
An example can help clarify the power inherent with the leverage provided by stocks options:
Say the stock goes up 50% to $30. You have added $10 per share to your profit. Now let’s look at the flip side where the stock goes down 50% and is now valued at $10. In this instance you’ve only lost the $5 of intrinsic value that was initially available (a 33% decline)!
Valuing Your Options
The black scholes model is the most widely used method for calculating the value of an option. It’s a complicated formula used to calculate the total value of a stock option which includes the intrinsic and time value components. While the intrinsic value is a simple calculation, the black scholes formula allows you to provide an estimate and assign a numerical value to the time value component of an option.
While this formula can help you grasp the importance and relevance of time value, it is by no means a prediction of a potential outcome of holding onto an option.
The formula uses 6 factors to determine the value of an option:
- Exercise price of the option
- Current value of the stock
- Time left until expiration
- Risk free interest rate
- Dividend yield of the stock
- Expected volatility of the stock
The final three factors are worth diving into.
Risk Free Interest Rate
An interest free loan is more valuable when interest rates are higher. Interest rates have been historically low for the past few years, but the recent volatility has resulted in a sharp increase in interest rates along the yield curve. Higher interest rates will produce a higher black scholes valuation.
As for dividends, companies that do not pay dividends accumulate profits internally, and hopefully, allocate those profits towards expenditures that will increase their assets. An increase in assets (when done correctly) helps the stock price go up. Additionally, option holders typically don’t receive dividends before they exercise which means they are better off when the company isn’t issuing dividends. In the context of black scholes, dividends decrease the value of an option.
Expected or Historical Volatility
Lastly, volatility is the investment industry’s definition of risk. Although generally viewed as undesirable in many instances, volatility actually increases the value of an option. Highly volatile stocks increase the probability of extreme swings, both positive and negative, for a given stock. Given the floor the exercise price provides, option holders can reap the rewards of volatility that lead to higher values, and are limited on the downside.
This combination of theoretically unlimited upside with limited downside makes a volatile stock more attractive to an option holder. However, an option that is deep in the money (high intrinsic value) creates additional room on the downside and limits the value of volatility going forward.
The Impact of Intrinsic Value on Time Value
We will stick with the previous example to help explain the impact of increasing intrinsic value on time value.
Let’s say the price rapidly increases to $75 per share.
- The interest free loan of the exercise price ($15) still exists.
- The favorable asymmetry we highlighted still exists, but the time value has decreased considerably because the $15 floor is so far below the current price.
The floor of $15 still exists if you were to hold the option, however, with the stock price at $75, the exercise price is now 76% below the stock value. A 50% decline in the stock value costs you $37.50, the same amount that you would gain on a 50% increase.
You can see how the leverage and time value has been reduced considerably as the current value of the stock increased in price. The same advantage highlighted in the first example no longer exists. Understanding this dynamic can help you determine when the time value has diminished to the point where exercising may be appropriate.
Considerations When Deciding to Exercise Your Options
1. It rarely makes sense to exercise your NSOs if you don’t plan on selling them soon thereafter and there are years left until the expiration date.
While there may be potential tax benefits to exercising early, and you have the potential of receiving dividends once you exercise, there are a few considerations to keep in mind.
When you exercise you have to pay the exercise price on the options. This cash could be used to fund other, more pressing, financial goals. It could also be applied to debt reduction strategies. Additionally, you give up the leverage. Once you exercise your options you lose the downside protection provided by the exercise price.
2. It does not make sense to exercise publicly traded options that are not in the money (positive intrinsic value).
This one is straight forward. You can buy the stock in the market if you would like exposure to your company’s stock.
3. Keep track of option expiration dates to avoid the missed opportunity of having options expire while in the money.
It is important to track expiration dates if you plan on holding your options. This is especially important if you are considering leaving, or recently left your employer. Options typically follow expedited expiration dates upon termination (most commonly 90 days). This can put you in a tough position and force you to exercise in a sub-optimal environment. Along the same lines, forgetting about options and having them expire while they are in the money is simply leaving hard earned money on the table.
- Understanding the components of stock option valuation can help you grasp the power and importance of leverage inherent in your options.
- Valuing your options using the black scholes or other models, while not perfect, can help you understand the tradeoffs between exercising and holding onto your options.
- Incorporating your equity compensation into your holistic financial plan can provide the “why” behind your equity compensation strategy and help optimize the chances of reaching your unique goals.
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