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Stock Option Valuation
How to find the value of your employee stock options.
Knowing the value of your stock options can help you evaluate your
compensation package and make decisions about how to handle your stock
Understanding Option Value
As explained more fully in our book
Consider Your Options, the
value of a stock option has two components. One part, called
intrinsic value, measures the paper profit (if any) that's
built in at the time we determine the value. For example, if
your option gives you the right to purchase stock at $10 per
share and the stock is trading at $12, your option has an
intrinsic value of $2 per share.
The option has additional value based on the potential for
greater profit if you continue to hold the option. This part of
the value varies depending on the amount of time until the
option expires (among other factors), so it's called the time
value of the option. The value of a stock option is the sum
of its intrinsic value and its time value.
It's important to understand that option value is not a
prediction, or even an estimate of the likely outcome from
continuing to hold an option. Your option may have a value of $5
per share, but end up producing a profit of $25 per share — or
no profit at all. Option value is useful information, but it
doesn't foretell the future.
Objective and Subjective Value
In theory, we can determine option value objectively using
complicated formulas or procedures. In practice, the value that
matters for people who hold employee stock options is the
subjective value of the option: the value of the option
to you. That's why I recommend a simplified approach when
determining the value of an employee stock option. For one
thing, if your option's expiration date is more than five years
away, I would determine the value as if it expires in five
years. The chances are pretty good that you won't get the full
benefit of a longer period of time. Also, I ignore any added
value produced by high volatility. That's a way of
measuring how much the stock zigzags up and down. In theory,
higher volatility means higher option value, but in practice it
exposes you to a lot of risk, and that's a negative factor that
cancels out the higher value, in my opinion. For planning
purposes, I nearly always determine the value of employee stock
options as if the stock has moderate volatility, even if the
actual volatility produces a higher theoretical value.
These observations about subjective value allow us to use
some shortcuts. The easiest one is for brand new options that
have a life of five or more years. The option doesn't have any
intrinsic value yet because the exercise price is the same as
the market value of the stock. If we ignore additional time
beyond five years, and also ignore the value of high volatility,
a newly issued option usually has a value close to 30% of the
value of the stock.
Example: You receive an option to buy $800 shares
of stock at $25 per share. The total value of the shares is
$20,000, so the option value is around $6,000.
Remember, the theoretical value of the option may be quite a
bit higher, but $6,000 is a reasonable figure for the value of
the option to you.
If you've held your option for a while and the stock price
has gone up, you need a slightly more complicated method to determine the
option's value. The "official" formula is truly mind-boggling,
but the following procedure gives you a reasonable estimate:
- Subtract the exercise price of the stock option from the
current value of the stock to determine the intrinsic value
of the option.
- Multiply the exercise price of the stock option by 25%, to get an estimate of the
time value. Reduce that number proportionately if the option
will expire in less than five years.
- Add the intrinsic value and the time value to get the
total value of the stock option.
Example: Your option lets you buy stock at $10 per
share. The stock is currently trading at $16, and the option
will expire in four years.
The intrinsic value is $6 per share. The five-year time value
would be $2.50 (25% of the $10.00 exercise price), but we reduce
that number by one-fifth because the option will expire in four
years. For this option, the intrinsic value is $6.00 per share
and the time value is about $2.00 per share. The total value of
the option at this point in time is about $8.00 per share.
Check your work: The time value of a stock option
is always somewhere between zero and the exercise price of
the option. A number outside that range indicates a mistake.
You probably won't be able to do this calculation in your
head, but it's pretty easy with a calculator, and that's more
than we can say for the Black-Scholes formula. Bear in mind that
here again we're ignoring the added value of high volatility, so
the theoretical value of a stock option may be higher than the
number calculated using this simplified procedure.
Dividends reduce the value of stock options, because option
holders don't receive dividends until after the exercise the
option and hold the shares. If your company pays dividends, it
makes sense to reduce the values calculated by the shortcut
methods described above.
Need an Online Calculator?
There are a number of stock option value calculators on the
Internet. Some are no good at all, but some are excellent — and
free. My favorite is offered by IVolatility.com. Read our
explanation first, then go to
this page and
look for a link to their Basic Calculator.
Start out by entering the symbol for your company's stock in
the box for "symbol." For example, if you work for Intel, enter
INTC. Ignore the box for "style" because that doesn't matter for
this type of option. The next box is for "price," and it should
already have a recent price for your company's stock. You can
leave it alone, or change it if you want to see the option value
when the stock price is higher or lower.
The next box is for "strike," which means the exercise price
of your stock option. Enter that number and skip over
"expiration date," because you're going to enter the number of
days to expiration instead. Don't worry about calculating the
exact number of days; just figure the years or months and
multiply by 365 or 30.
The next box is for volatility, and if you entered a good
stock symbol, the number is already there. How cool is that? If
the number is 30 or less, just accept it and move on. If it's
higher than 30, I'd be inclined to discount it to 30 in most
cases because your options expose you to a lot of risk.
You can accept or change the values the calculator offers for interest
rate and dividends. Normally there is no reason to change these
items. Press "calculate" and after a moment you'll see the value
of the option (and lots of other stuff that will literally be
Greek to you).
Note that this calculator gives the total value of your stock
option. If your option is "in the money" (meaning the stock is
trading at a price higher than the exercise price of the
option), part of the value is intrinsic value and part is time
value. Subtract the exercise price of the option from the
trading price of the stock to get the intrinsic value. Then you
can subtract the intrinsic value from the overall value to learn
the time value of your stock option.