Valuing Stock Warrants

The SEC has publicly stated its preference that companies begin using more complex option valuation models than Black-Scholes.

The SEC has publicly stated its preference that companies begin using more complex option valuation models than Black-Scholes.

Investors have become increasingly upset over the very large compensation packages received by management teams, often regardless of the underlying performance of the company. In an effort to tie management compensation to the underlying performance of the company, the use of warrants has proliferated to demonstrate clear incentives for management teams to maximize shareholder wealth. This reduces agency risk while creating a merit-based system for promotion within the company. Warrants are issued by the company directly to individuals, as opposed to options trading on secondary exchanges. This provides a source of cash inflows for the company, which is another benefit of the use of warrants.

Review Warrant Grant Agreement

Read the warrant grant agreement to obtain the terms of the warrant, such as its maturity date, purpose of the grant, the strike price and the type of warrant issued. If you are valuing the warrants for financial reporting purposes, you may need to learn the nuances between fair value and fair market value by reviewing Accounting Standard Codification 820. Most warrants issued in the U.S. are American-style warrants, which allow its owner to exercise the warrant at any time prior to the warrant’s maturity. European-style warrants allow for the exercising of the warrant only at the warrant’s expiration date.

Determine Volatility

One of the most important drivers of the value of a warrant is the underlying stock’s annualized volatility. Higher volatility results in an increased warrant value. This makes sense intuitively because if a stock price exhibits large erratic price swings, this generally increases the probability that the strike price will be reached or even exceeded. Obtain information on volatility by downloading historical daily stock prices into a spreadsheet, then using the spreadsheet program’s embedded formula templates. Download historical pricing information for a period that matches the maturity of the warrant.

Private Company vs. Public Company

Stock in a private company is not valued every day, as is the case with publicly traded stocks, which makes it more difficult to estimate an appropriate volatility level. You have several options for estimating an appropriate volatility rate. You can use the volatility rate of publicly traded stocks that are members of an index, such as an industry index, that closely matches the subject company’s line of business. Another option is to use the historical volatility of the subject company’s return on equity, which is highly correlated to stock market returns.

Notes on Calculating Volatility

An accurate measurement of volatility is a key component of valuing a stock warrant. The simple route is to use formulas embedded in a spreadsheet. However, to calculate annualized volatility manually, download historical daily price information into a spreadsheet column. In the next column, calculate each day's return over the previous day's value. At the bottom of this column enter "=StdDev()" and enter the column's cell range into the parenthesis. This produces the stock's daily volatility. Annualized volatility equals daily volatility multiplied by Sqrt(252). The term "Sqrt(252)" is exactly how you would enter it into the spreadsheet. This assumes 252 trading days in a year, because it excludes weekends. If you had previously downloaded weekly information into the first column, then you would multiply the weekly volatility by the term "Sqrt(52)" to annualize it. This process appears complex, but it is made easier using spreadsheets, and by familiarizing yourself with the basic concepts of volatility and standard deviation.

Calculating the Warrant's Value

In the case of a private company, the fair market value of the subject company’s stock must be determined as of the date of the warrant grant. You should also obtain the yield of a Treasury note with as close a duration as possible to the terms of the warrant. Using all the inputs discussed before, you can perform a Monte-Carlo simulation or a Black-Scholes methodology to obtain an actual warrant value. These are very complex calculations for which numerous software packages are available. Also, there are many free warrant calculators available online from highly reputable sources. In these cases you simply enter the inputs into the model and a number is produced. As a measure of your results, use a wide variety of warrant value calculators to determine if they all produce similar values.

 

Photo Credits

  • Comstock/Comstock/Getty Images