by Bill Dillhoefer, MBA
Determining the right time to exercise one’s employee stock options is the key to maximizing the value of this benefit. Stock options are granted at a fixed exercise price and then must be exercised after vesting and prior to the expiration date to realize their value. During the time between vesting and expiration the current stock price for publicly traded companies is likely to fluctuate significantly and no one can predict the peaks and valleys. Consequently, it is important to have a disciplined approach for making profitable exercise and sell decisions (FYI, there is no good reason for exercising and holding Non-Qualified Stock Options, but that’s a topic for another article).
The secret to profitable employee stock option exercise decisions lies within the four main factors that affect their value:
- The length of time until expiration; the shorter the time, the lower the probability that the value of the option will increase prior to expiration.
- The in-the-money or intrinsic value (current stock price minus exercise price); the greater the in-the-money value, the more one has to lose by continuing to hold the option.
- The expected volatility of the stock (a measure of the extent to which the price has fluctuated over time); the higher the volatility, the greater the probability that there will be higher peaks and lower valleys in the stock price prior to expiration.
- The risk free rate of return (the rate on midterm Treasury bonds); an option’s value is enhanced by the return on the capital that would otherwise be invested in the stock in some other investment. The risk free rate represents the return on this other investment.
The interaction of these factors is complex but there is a widely accepted methodology that uses them to calculate the full value of a stock option. The Black-Scholes formula developed by Fischer Black and Myron Scholes was awarded the Nobel prize in economics in 1997. Although the mathematics are somewhat complicated, the fundamental concept is that the value of a stock option is more than just its in-the-money value. This is based on the probability that the stock price will will be higher than the exercise price before the option expires. That is why options that are somewhat underwater (current stock price less than exercise price) can still have considerable value. The difference between the Black-Scholes (or full) value of an option and the in-the-money (or intrinsic) value is the “time value”. In other words, the full value of an option equals the in-the-money value plus the time value.
If we then divide the time value (TV) by the Black-Scholes value (BSV) and express it as a percentage, the resulting ratio represents the risk-reward trade-off of holding the option vs. exercising and selling it. This ratio was coined the “Insight Ratio®” because it provides insights into determining when to exercise. For example, an option with $10,000 of vested time value and $100,000 of vested Black Scholes value would have an Insight Ratio of 10% meaning that 90% of this option’s value ($90,000) is currently in-the-money value (BSV – TV = ITMV). If this ratio is low (i.e. under 20%), the option is a good candidate for exercising because there is a large amount of intrinsic value at risk compared to the probability of further gain (time value). To further clarify this, let’s look at an example that calculates several Insight Ratios using the following assumptions:
- Current Date: 4/18/13 (for calculating time to expiration)
- Current Stock Price: $82.56 (Deere & Company, for calculating intrinsic value)
- Volatility: 33.60% (from 2012 annual report)
- Risk Free Rate: 2.00% (from 2012 annual report)
The following observations can be construed from the above Insight Ratio table (calculations by StockOpter.com):
- The first grant (NQ2005) is about 2.5 years from expiration and deep in-the-money ($58/share) so consequently it has a low Insight Ratio. By continuing to hold this option the recipient is risking $192,480 of in-the-month for $9,104 of time value.
- The 3rd grant (NQ2007) is under water (exercise price greater than the current stock price), but there is $95,606 worth of time value because it has 4.5 years to expiration and moderate stock price volatility (33.6%). By definition, the Insight Ratio for under water options is 100%.
- NQ2010 is slightly in-the-money and has 7.5 years left so time value makes up 94% of its full value. It would not be wise to exercise this option now because it would mean forgoing a large amount of upside potential for a small amount of intrinsic value.
- The 2011 and 2012 grants are not yet vested so they have no exercisable in-the-money value or time value. The Insight Ratio for unvested grants is also 100%.
Over the past decade the Insight Ratio has been used by hundreds of financial advisors to guide the stock option exercise decisions of their clients. Typically, an Insight Ratio of between 10% and 20% is used to trigger an exercise “evaluation.” The specific ratio used to trigger action may be adjusted up or down based on the following personal financial assumptions:
- Use a lower ratio if there are sufficient diversified assets to meet the financial goal
- Use a lower ratio if there is a long planning horizon (i.e. 10+ years to retirement)
- Use a higher ratio if you are highly concentrated in company stock and options
- Use a higher ratio if you are nearing retirement and have yet to achieve your financial goal
Let’s assume the executive holding the grants listed above is 15 years from retiring, hasn’t met his financial goal and is moderately concentrated in their company stock and options. Given these Insight Ratios and personal assumptions, it would be reasonable to exercise and sell the 2005 grant and then continue to monitor the other grants (particularly NQ2008 and NQ2006). When the Insight Ratios go below 11% a re-evaluation of the executive’s financial situation would be in order.
The secret to maximizing the value of ones employee stock options is fairly straight-forward. Commit to a disciplined approach that uses the Insight Ratio to compare the risk (realized intrinsic value) to the reward (time value). Otherwise, the alternatives are: 1) trying to predict when the stock price will peak or 2) hoping for the best right before the option expires.
Bill Dillhoefer is vice president at Net Worth Strategies, Inc. a service firm specializing in personalized equity compensation management. Bill led the development effort of a web-based stock plan decision support platform: www.StockOpter.com. This system is used by most of the major financial service firms to assist clients with company stock and options. He is the editor of the StockOpter University Blog which is dedicated to the topics of when to exercise employee stock options and diversify company stock holdings. Bill has spoken at the NASPP conference and to numerous advisor groups. Connect with him on LinkedIn or follow him @StockOpter.