P&G's Record Prices - What To Do With Your Stock Options - Part 2 of 4
WHAT IS THE VALUE OF P&G STOCK OPTIONS?
In our last blog, we discussed an example using the February 2012 grant of 13,000 shares of P&G stock options and discussed how the “Today’s Value” of that example grant has varied widely just in the last few months. If you missed that blog, you can catch up here...
Today we’ll introduce a mathematically-based methodology for analyzing our example grant and think through a better risk-adjusted metric for discussing this example grant series. It’s one of the metrics we use in “The Stock Options Analyzer” TM that gives us the ability to guide our clients in arriving at wiser and more appropriate conclusions when it comes to deciding when to exercise some or all of their stock option grants for any particular series of options.
WHAT IS THE BLACK SCHOLES VALUATION?
One component of “The Stock Options Analyzer” TM that needs to be understood is the Black-Scholes valuation formula. Put simply, it is a methodology designed to calculate (as much as possible) the true or full value of derivative instruments (such as options). To start learning more about this approach and trying to decipher the value of options, click here...
But, for simplicity and for the purposes of looking at our example 2012 grant, we just need to understand that the Black Scholes formula has some inherent limitations when it comes to valuing employee stock options such as P&G stock options. The model really is much better equipped to deal with traded options (rather than employee stock options) and European style options (which have a fixed expiration date as opposed to P&G stock options which can be exercised prior to expiration). The Black Scholes formula does, however, help to provide some context to use when analyzing a grant series and is one factor in working our way toward deciding when to consider exercising a specific stock option grant.
HOW IS THE BLACK SCHOLES VALUATION DETERMINED?
Put very simply, the concept of the Black Scholes model is to take the “Today’s Value” of a stock option grant (as we discussed last time) and to add to it the “future value” of the grant in order to determine a more realistic “full value” for a particular grant. The “future value” or “time value” of a stock option grant is important because we only have a limited amount of time in which to exercise each stock option grant. The closer we get to the end point of that timeframe (i.e., the expiration date of the stock option grant), the more risk we take on in our valuation process. Another way to think about “time value” is the value of the opportunity to continue to hold a stock option versus exercising it now.
Full Option Value (FOV) = Today’s Value + Time Value (TV)
Using the February 2012 grant, here is a breakdown of the “Full Value.” For hypothetical illustrative purposes, let’s use a PG stock price of $141/share. Today’s Value is the "in the money market value" and from our last blog we know Today's Value is $955,240.
Obviously, for the February 2012 grant, most of the value and opportunity is “Today’s Value” and not the remaining time value. For other grants not as close to expiration, time value’s contribution to the full value only increases.
If P&G stock declines in price (or especially if it goes down dramatically closer to the expiration of the grant series), our timeframe and ability to have the stock price recover before the drop-dead deadline to exercise and realize the value of the option grant becomes greatly impaired. Going back to our “hold ‘em or fold ‘em” analogy, the longer we stay at the table, the better the chance that our winnings may grow and grow. But, if we’re dealt the wrong hand at the wrong time, a painful amount of those winnings can be wiped off the table in a very short period of time and we will have wished that we had been willing to “fold ‘em” rather than “hold ‘em”… And so it is with P&G stock options.
P&G STOCK OPTIONS ARE A UNIQUE FINANCAL INSTRUMENT
So, again, to simplify a bit, P&G stock options are a unique financial instrument because we need to look at not only what they are worth today but what they might be worth (given the leverage of the options) between now and when they expire. The Black Scholes valuation attempts to help us clarify this equation and considers such things as the implied volatility of P&G stock, how much time is left before expiration, the rate of return that can be earned with little or no risk and the relation of the current P&G stock price to the option’s grant price. It’s not an answer to the biggest question most clients have which is “When to exercise my stock options?” but it’s one helpful step in the process we use to help determine the answer to this question.
In our next blog, we will introduce "The Clarity Options Ratio" TM. This uses the Black Scholes valuation in relation to some other important metrics to help us determine the trade-off between the current P&G stock price and the potential for additional growth before the expiration date and the potential for losing some or all of the value already present in the stock option grant thus far.
In the meantime, if you would like to discuss your stock options, have any questions or if we can help in any way, please feel free to contact us at ClarityWealth@LFG.com or 513-745-7095.
Jay A. Finke, CFP®, Matt A. Held, CFP® and Robert V. Molenda, CLU, ChFC, CRPC®