Chapter 8 expected future cash flows to the amount invested
today.
The Valuation and Characteristics of Stock
Common Stock
• Corporations are owned by holders
of their common stock.
• Stockholders choose directors, who
appoint managers to run the company.
• This means that stockholders have a
voice in running the company through BoD
Most large companies are widely held, stock
ownership is held by a large number of people and
no individuals or groups control more than a few
percent.
Stockholders have little power to influence
corporate decisions, and stock ownership is simply
an investment.
When buying stock, our role is not as owner. Most
equity investors are not interested in a role of
owners. We’re just interested in the future cash
flows that come from owning shares.
Equity (stock) investments are like debt (bond)
investments; we’re only interested in money.
The Return on an Investment in Common Stock
The income in stock investment comes in two
forms:
(1) Receiving dividends
(2) Realize a gain or loss on the difference
between the price they pay for stock and
the price which they eventually sell it
(capital gain or loss)
The future cash flow associated with stock
ownership consists of dividends and the eventual
selling price of the shares.
The return on stock investment is the interest rate
that equates the present value of the investment’s
 The return on any stock investment is the rate
that makes the present value of future cash
flows equal to the price paid for the investment
today. This principle also holds for investments
held for more than one year.
Dividend and Capital Gain Yields – The return on
a stock investment can be broken into two parts
related to the two sources of income of stocks. The
return on a stock investment comes from dividends
and capital gains.
The Nature of Cash Flows from Common
Stock Ownership
Comparison of Cash Flows from Stocks and
Bonds – Cash flow pattern for stocks appears
similar to the one associated with bonds. A series of
regular payments is followed by a single larger
payment that can be thought of as the return of the
original investment.
 Dividends – analogous to interest payments
 Final sale of stock – appears to be like the
return of a bond’s principal.
The reality is that the similarity is superficial
because of the differing natures of the cash flows in
the two cases.
a) Bond – interest payments are guaranteed by
the borrower, are certain to be received.
Companies have to be VERY close to
failures before they declare default on bond
interest. Interest payments in bonds are in
constant or fixed amount, making it easy to
develop a formula to value bonds, because
interest can be represented as annuity.
Payments are contractually promised loan
principal equal to bond’s face value
b) Dividends – carry NO guarantee. There’s
NO agreement associated in common stock
that makes any representation about the
payment of dividends. Investors depend on
them for value but nothings is committed,
promised, or guaranteed by the company.
 Even with a long history of payments,
companies could stop paying anytime.
Interest on dividends are rarely constant,
people can expect dividends to increase
over time as company grows. Stockholders
has to sell their shares at the prevailing
market price to realize a final payment
which can be higher or lower than the price
originally paid.
There’s NO provision in a common stock
investment for the repurchase of shares or for any
return of the investor’s capital by the company,
which means that the money for the final payment
comes from another investor rather than from the
issuing company as it does with a bond.
Both the cash flows with stock ownership are
dividends and the proceeds of the eventual sales of
the share are imprecise and difficult to forecast.
The Basis of Value The basis for stock value is
the present value of expected cash inflows even
though dividends and stock prices are difficult to
forecast.
A stock’s value is the sum of the present value of
dividend payments and the present value of the
selling price in a period. Successive dividends have
different values.
Valuing a stock involves making some assumptions
about what its future dividends and its eventual
selling price will be. Once this has been done, we
take the value assumed (projected) cash flows at an
appropriate interest rate to estimate the share’s
current price.
 Contrast to bond valuation, bonds have no
need to make assumptions about the future
cash flows because they were spelled out by
the bond contract.
A generalized stock valuation formula from these
ideas by treating the dividends and the selling price
as a series of independent amounts to be received at
various time in the future.
The Intrinsic (Calculated) Value and
Market Price – The present value cash flows is
fundamentally what the stock is worth (the stock’s
intrinsic value).
 If other investors does not agree with the
stated dividend and price estimates, their
ideas of the intrinsic value of that dividend
will differ from the statement of the other
investor.
The firm’s market price is the consensus of the
intrinsic values calculated by everyone watching
the stock. The process of developing intrinsic
values and comparing them with market prices is
known as fundamental analysis.
A stocks intrinsic value is based on the assumptions
about future cash flows made from fundamental
analysis of the firm and its industry.
Growth Models of Common Stock
Valuation
Generally, we can’t forecast the future in detail.
We’re likely to look at a company and simply
forecast a growth rate of earnings and dividends
into the future starting from wherever they are now.
The future is uncertain, it’s difficult to make the
detailed forecast of dividend and future prices
needed to use. Stock valuation models are based on
predicted growth rates because forecasting exact
future prices and dividends are very difficult.
Developing Growth-Based Models
Stock dividends and eventual selling price are
separate amounts in the present valuing process,
each multiplied to the present value factor for the
appropriate interest rate and time.
A stock’s value today is the sum of the present
values of the dividends received while the investor
holds it and the price for which it is eventually sold.
An Infinite Stream of Dividends – The concept of
stock ownership is :
1. Buy
2. Hold for a while
3. Sell
The present value of any amount that is infinitely
far away in time is clearly zero.
Conceptually, it’s possible to replace the final
selling price with an infinite series of dividends.
Market-Based Argument – Individual investors are
a whole community; Individual investors will
subsequently trade the stock back and forth among
themselves, and act as one unified body setting a
price for the stock when it is issued. The price must
be based on the present value of future cash flows
moving from the company to the investing
community, with only one kind of payment moving
from company to investors (dividends).
The only basis for valuation by the community as a
whole is the entire future stream of dividends;
nothing else.
Working with Growth Rates – Growth rates usually
used to predict future values of variables whose
values are known today.
The Constant Growth Model
Subsequent dividends can have any values,
randomly chosen or a regular progression of
numbers. When the last dividend is paid, we
assume that dividends will grow at some constant
rate in the future.
Any fraction whose denominator is much larger
than its numerator is a very small number.
The entire expression in brackets is a finite number
when K (return) is greater than g (growth rate). In
this case, we’re forecasting normal growth. When g
os greater than k, we have super normal growth
which lasts for limited periods.
Constant Normal Growth – The Gordon
Model – Constant growth model assumes that the
stock’s dividends are going to grow at a constant
rate into the indefinite future. It is also called the
Gordon Model after Myron J. Gordon, a scholar
behind its development and popularization. It only
works if growth is normal, K>g. Otherwise the
denominator is negative (or zero) leading to a
negative (or undefined) price which isn’t
meaningful.
The Gordon Model is a simple expression for
forecasting the price of a stock that’s expected to
grow at a constant, normal rate.
The Zero Growth Rate – A Constant
Dividend – A perpetuity is an unchanging
payment made regularly for the indefinite period
of time. Common stock will not pay the same
dividend forever. A security called preferred stock
pays the same dividend year after year with no
expectation of increase or decrease.
The Expected Return
The Gordon Model can be recast to focus on the
return on the stock investment implied by the
constant growth rate assumption. The capital gain
yields in the Gordon Model is nothing but the
growth rate.
The expected return reflects the investors’
knowledge of the company. It is input to the
Gordon model through the growth rate assumption.
Two – Stage Growth
We know something about the near – term future
that can be expected to have a temporary effect on
the firm’s prospects.
The usual two-stage forecast involves a rapid, super
normal growth rate for one, two, or even three years
and a normal rate thereafter. Super normal means a
rate in excess of return of stock (k).
The model gives us a value for a share of stock at
the beginning of an infinite periods of constant,
normal growth.
A normal growth that starts at the end of the second
year, when the Gordon model will be applied, the
result is a price for the stock at the end of the
second year, or equivalently at the beginning of the
third. It includes the value of all dividends to be
paid subsequent to the second year but not the
dividend of the second year itself.
The two – stage growth model allows us to value a
stock that’s expected to grow at an unusual rate for
a limited time.
The value of a security today is the present value of
future cash that comes from owning it.
Practical Limitations of Pricing Models
The inputs in the model are only projected growth
rates and interest rates. They are not accurate.
Comparison with Bond Valuation – The
inaccuracy only refers to stock valuation; bonds
have bond pricing model that gives a precise
valuation for the security, because the future cash
flows are contractually guaranteed in amount and
time, unless a borrowing company defaults its
obligations (rare in higher grade issues), we can
predict the exact pattern of future interest and
principal payments. Yields in turn are established
accurately by market forces influenced by the
stability of the issuing company and the term of
debt.
Stock Valuation models give approximate results
because the inputs are approximation of reality.
Bond valuation is precise because the inputs are
exact.
Stocks That Don’t Pay Dividends – Some
companies don’t pay dividends even when their
profits are high; many openly states that they never
pay dividends. However, the stocks of these firms
have substantial values.
The previous growth models have been working
with base stock values solely on the present value
of a dividend stream.
Firms that don’t pay dividends even when their
earning are good are usually in an early period of
their development and are growing rapidly. Growth
requires cash, and management feels it’s futile to
pay dividends only to borrow or issue more stocks
to support the growth of the company. Stockholders
agree because they hope to own a piece of a much
larger company if growth continues.
Most people understand that rapid growth is not
forever. When the growth in the industry and firm
slow down, even the most vocal non-dividend pays
are eventually begin paying. Stock that don’t pay
dividends today are expected to pay large dividends
at some time in the future; those distant dividends
impart value.
If a company truly never paid a dividend, there
would be no way for the investing community as a
whole to ever get a return on its investment.
Valuing New Stocks – Investment
Banking and the Initial Public Offering (IPO)
Emerging stocks that are being sold to the public
for the time are called Initial Public Offerings
(IPO). They are valued differently than stocks that
have been around for a while, which shouldn’t be
the case, but as a practical matter, things are less
rational in IPO segment of the equity market.
IPOs for Different Securities
IPOs that generate the most excitement sell the
stocks of new companies, but there are IPOs for
other new securities, notably bonds. There are
actually more
IPOs for bonds than stocks because new bonds can
be issued to replace older, maturing bonds as well
as to raise new money.
The sale of new shares of an existing stock is
handled like an IPO but is actually a seasoned
equity offering (SEO) or a secondary equity
offering. These aren’t especially interesting from a
pricing perspective, but the market value of old
shares determines the price of the new. (The new
shares may be offered slightly below market to
ensure their sale).
The IPOs here are the first public sales of a new
company stocks, that is, the first time people other
than founders and private investors have an
opportunity to buy in, which happens when the
founding group wants to raise a lot of money, to
support growth.
The shares sold in an IPO are new, but the offering
usually includes some existing shares that were
previously issued to founders and early investors.
Although these shares are sold within the IPO
process, they actually constitute a secondary
offering.
IPOs may include shares owned by founders and
early investors.
Investment Banking
The first step toward an IPO is establishing a
relationship with an investment bank, an
organization that specializes in marketing new
securities. This banks specializes in different areas.
An investment bank sells new securities to
investors.
1. Syndication – Most IPOs are too big and carry
too much risk for a single investment bank, so a
lead bank recruits others, forming a syndicate
which shares the process. The lead bank
(Principal or Managing investment bank) is in
charge.
2. Registration – Filing a registration statement,
Form S-1 with the SEC. A summary of the
information, known as Prospectus, is part of the
S-1 document, intended for distribution to
potential investors. The lead investment bank
advises the company during this stage.
3. Underwriting – Investment banks solve the
problem of lowering the price of shares by
underwriting IPOs. Underwriting IPOs makes a
firm commitment to buy the stock from the
new company at a fixed price and is then
responsible for reselling the shares to investors.
The bank sells the shares at a higher price than
it paid. The difference is the underwriting
spread. This way, investment banks earn profits;
companies understands that the spread act as the
fee paid for banking services. The investment
bank syndicate is also called an underwriting
syndicate and the investment bank is called
underwriter.
Best Efforts – Smaller deals does not use
underwriting but accept a placement on a best effort
basis. It means that issuing company gets whatever
the bank is able to sell the new shares for, less
expenses and commission.
Promoting and Pricing the IPO
Quiet Period - is the period that begins when the
registration statement is filed until the SEC accepts
the statement by declaring it effective. During this
period, executives and representatives show
potential investors the prospectus stamped with red
ink “preliminary“ but may not share any other
information about the company or finalize any
orders for stock. Preliminary prospectus are known
as red herring. The prospectus contains price range
for the IPO stock but not the exact offering.
The second quiet period begins days after trading
begins. None associated with the company or IPO
can issue any forecast or analysis of the company’s
projected performance. This ensures all investors
have equal access to information.
During the quiet period, the preliminary prospectus
(red herring) is distributed, but no stock may be
sold.
Book Building and the Road Show
IPOs are promoted during road shows, in the
process of book building.
The road show is fast and intense trip of companies
around the country, with the purpose of
promotional presentations on the new company and
IPO to potential institutional clients held by
investment bank.
The purpose of the trip is to make promotional
presentations on the new company and the IPO to
potential investors, which most are the investment
banks institutional client. After each shows, the
banks asks the investors how much shares they’re
willing to buy, recorded in the book that builds into
an order list.
The road show generally ends at about the same
time the SEC approves the registration statement
which is shortly before the IPO date.
The bank then allocates the IPO shares among the
investor who expressed interest during the road
show. In most cases, the investment bank places the
majority of the IPO stock with these large, special
relationship investors rather than with the general
public who are called retail investors. IPO buyers
tend to be large, powerful organizations that are
“insiders“ in the financial system.
The sale of the IPO shares is an off market
transaction, meaning it isn’t the result of an
auction- like process as are ordinary stock trades.
The price is set by the investment bank and the
issuing company, based on information from the
book building process, and all shares sold at that
price.
Prices After the IPO
The Investment Bank in the Middle – The
investment bank is in the center of the IPO
process. It stands between the issuing company
and the investors who buy the shares. Both of
these are the bank’s clients and have put their trust
in the banker, but their interests conflict. The
company wants to get as much as it can for its
stock, while the investors want a very high return
on their money, only when securities are acquired
for less than full value. The issuing company ang
investors are both clients of the investment bank.
IPOs have a strong tendency to be underpriced to
reward investors to make the stock’s price go up
right after the IPO. A rapid increase in price when
trading begins is an IPO pop.
Underpricing may happen because investment
bankers know they’re likely to be marketing shares
in another IPO to the same investors.
The idea of IPO pop is to purchase shares, hold
them while the price increases quickly and then sell
after only a few days before the price falls again.
Investors that use this strategy is called a stag and
the gain is a stage profit. A pop – based strategy
available to less privileged investors is simply to
buy as soon as possible after the trading starts,
watch the rising price very carefully, and sell the
moment it starts down.
Market Stabilization Investment banks support
the new stock’s price to keep it above the IPO price.
The lead investment bank is actually committed to
supporting a small pop by keeping the price of the
stock above the IPO price during the first few days
of trading. It does that by purchasing shares if the
market for the issue is weak. If demand is very
weak, stabilization may be impossible.
Price in the Longer Run and the Retail Investor
Most IPO pops don’t last, and the stocks usually
underperform for years. The result of underpricing
and the pop phenomenon is bad for retail investors.
Interested in the company but unable to participate
in the IPO, they buy at pop – inflated prices only to
lose out when the stocks go down and stay down.
Some Institutional Characteristics of
Common Stock
Common stock represents an investment in equity
(ownership) that theoretically implies control of the
company. Ownership interest means a stockholder
has influence on the way the company is run,
depending on how much stock they own. Most
management issues are decided by a majority of
vote, stockholders owning minority interest have
little power when someone else has a clear majority
or when no one owns a substantial percentage of
the firm.
Corporate Organization and Control
Corporations are controlled by boards of directors
whose members are elected by stockholders. The
board appoints the senior management that appoints
the middle and lower management and runs the
company on a day-to-day basis. Strategic decisions
are made by the board, but big issues such as
mergers must be voted by stockholders. Corporate
boards are generally made of the company’s top
managers and a number of outside directors. Board
members may be a major stockholder.
Companies are widely held when stock ownership
is distributed among a large number of people and
no single party or group has a significantly large
share.
This makes it difficult to make a change in the
board because it’s hard to organize voting
stockholders against incumbent members. In
situations like this, members of top management on
the board have effective control of the company
with little accountability to stockholders. Top
managers effectively control widely held
companies, because no stockholder group has
enough power to remove them.
Kasi all shareholders nagvote para ielect sila, so
others might not want to remove them from the
board, lets say 100 shareholders elected them, e
hindi full 100 wants them out, so unless lahat
nagkaisa para alisin sila, they can’t be ousted. This
gives them control over the company.
Outside directors are supposed to be a restraint on
this autonomy of management, but generally don’t
do much along those lines.
The Role of the Equity Investor Most of the
investors who buy equity stock are not interested in
running the company, they’re only interested in
cash flows.
Preemptive Rights It allows stockholders to
maintain their proportionate ownership. When new
shares are issued, common stock – holders have the
right to purchase a portion of the new shares issued
equal to the percentage of the outstanding shares
they already own. Preemptive rights allow current
stockholders be offered this option before the new
shares are sold to others.
Preemptive rights are common, but no laws require
them. If stockholders have preemptive rights it’s
because they were in the company’s charter.
Voting Rights and Issues
Most common stock comes with voting rights,
each share gets an equal vote in the election of
directors and major issues. Voting issues are
usually limited to changes in the company’s
charter (broadly defines what it does, and
questions about mergers).
Stockholders vote on directors and other items at
an annual meeting that corporations are required
by law to hold. Each share of common stock has
one vote in the election of directors, usually cast
by proxies. Proxies give the authority to vote
shares to a designated party, they are the person
appointed to stand in for a shareholder at a general
meeting of members. A proxy fight is when parties
with conflicting interest solicit proxies at the same
time, usually happens when a stockholder group is
unhappy with management and tries to take over
the board. Proxy solicitations are efforts made by a
corporation or interested parties to persuade
shareholders to vote in a particular way on certain
issues during a shareholders’ meeting.
Majority and Cumulative Voting Traditional
voting (majority)gives the larger group control of
the company to the virtual exclusion of the minority
group because each director is chosen in a separate
election, so the majority vote can win every seat.
Cumulative Voting gives minority interests a
chance at some representation on the board. Each
share of stock gets one vote for every seat being
elected, the minority stockholders can cast all their
votes for one seat or split them up among several
elections. Minority interest can concentrate its votes
on one or two seats and be likely to win, getting
some board representation.
Shares with Different Voting Rights It’s possible
to issue more than one class of stock with different
rights associated with each class. A practice that
affects control involves issuing a class of stock with
limited voting rights or with no votes at all, and if
such an issue receives the same dividends as
traditional voting stock, it may attract typical
investor without interest in control.
Stockholders’ Claims on Income and
Assets
Common stockholders are last in line to receive
income or assets and bear more risk than other
investors, but their residual interest is large when
the firm does well. Stockholders have a residual
claim on both income and assets.
For Income, stockholders own what’s left after all
operating costs and expenses are paid, after
bondholders receive their interest and any principal
due, and after any preferred stockholders get their
dividends.
When business is bad, stockholders may not be paid
because the company might run out of money
before they’re paid.
This makes common stock the riskiest investment.
The residual income belonging to stockholders is
essentially the net income line on the income
statement, which may be paid out in dividends or
retained and reinvested in the business.
 Dividends – immediate money in their
pockets
 Retained Earnings – contribute to growth
that makes the stock more valuable.
For Assets, the residual position means that if the
corporation fails and is liquidated, stockholders
don’t get anything until everyone else is paid which
often means they don’t get anything at all.
Preferred Stock
It is a security that is between the bonds and
common stock, and has the characteristics of both;
a hybrid of the two. Preferred stock pays constant
dividend forever. When a share is initially issues,
two things are specified: the initial selling price in
the primary market call the stock’s par value, and
the dividend. The ratio between the two reflects the
current return on investments of similar risk, the
market interest rate.
The rate of preferred stock is similar to the coupon
rate of a bond, and the preferred’s initial selling
price (issue price) is similar to the bond’s face
value. Preferred stock is issued at prices (par
values). Like common stock, preferred stock carries
no provision for the return of capital to the investor.
The issuing company never has to pay the initial
selling price back.
Valuation of Preferred Stock
Purchasing a share of preferred stock receives a
constant dividend forever. All securities are worth
the present value of their future cash flows; a
preferred share is worth the present value of that
infinitely long stream of dividend payments.
Preferred stock pays a constant dividend and is
valued as a perpetuity.
PMT = Dp
Present value of the perpetuity PVp = Pp or the
security’s price.
Pp = Dp
K
Valuation of a preferred share is identical to zero
growth common share. Similar to bonds, preferred
shares issued yields the current rate of interest,
which when interest changes, they have to offer
competitive yields to new secondary market buyers.
This is accomplished through price change. Prices
of preferred stocks also moves inversely with
interest rates.
Characteristics of Preferred Stock
Cumulative Feature Enhances the safety for
investors, states that if preferred dividends are
passed (not paid), no common dividends can be
paid until the preferred dividends in arrears are
caught up. Common dividends can’t be paid unless
the dividends on cumulative preferred are current.
The features of preferred stock allow it to be
characterized as a cross between common stock and
bonds.
Comparing Preferred Stock with Common Stock
Payment to Investors - Preferred dividends are
constant and don’t grow even when the company
grows similar to bonds. Common stocks however,
grow with the firm.
Maturity and Return of Principal - Preferred stock
has no maturity and never returns principal unlike
bonds and common stocks.
Assurance of Payment - Preferred dividends can be
passed, subject to cumulative feature, which is
somewhere between bonds and stocks. A bond has a
maturity date and can force bankruptcy while
common stock can be passed indefinitely.
Priority in Bankruptcy- Bondholders have a claim
on company assets to the extent of unpaid principal
of the bonds. Common stockholders are entitled to
only what’s left, and Preferred stock are in between
because they have a claim in the amount of the
original selling price of the stock, but subordinate
to the claims of bondholders. It comes before the
interests of common stock and after the
bondholders.
Voting Rights - Common stockholders have voting
rights,. While preferred stockholders do not (like
bonds).
Tax Deductibility of Payments to
Investors - Interest is tax deductible to the paying
company, while dividends, common or preferred,
are not. Preferred stock is equity.
Legally, preferred stock is equity, but it acts like
debt which is why it is treated separately in
financial analysis.
The Order of Risk
Bonds are safest, common stock is risky and
preferred is in the middle. “Preferred stock comes
from the idea that of the two types of equity, you’d
rather have preferred stock if the firm does poorly
or fails.
Securities Analysis
It is the art and science of selecting investments.
Valuation is part of a broad process aimed at
selecting investments (securities analysis).
Fundamental Analysis looks at a company and its
business to forecast value.
Technical Analysis bases value on the pattern of
past prices and volumes. Volume refers to the
number of shares traded in a period. A price change
at a low volume of trading isn’t generally as
significant as the same change accompanied by a
higher volume.
The Efficient Market Hypothesis (EMH) says
information moves so rapidly in financial markets
that price changes occur immediately, so it’s
impossible to consistently beat the market to
bargains.
Options and Warrants
Options and Warrants make it possible to invest in
stocks without holding shares. Options are
securities that make it possible to invest in stocks
without holding shares. Option is a contract that
gives one party a temporary right to buy an asset
from the other at a fixed price. The option is a
purchase contract that’s suspended at the discretion
of the buyer for a limited time after which it
expires. Option holders can speculate on asset price
changes without holding the asset.
Stock Options
Stock Options convey the right to buy or sell
shares ON or BEFORE a specific date at a specific
price. They are bought to speculate (gamble) on
price movements. Stock options are themselves
securities and can be traded in financial market.
Call options are options to buy. Put options are
options to sell. Options are an example of
derivative security. The value of derivative
security is based on that of another underlying
security.
• Earnest – Deposit or downpayment
to demonstrate seriousness about buying
something (part of purchase price)
• Option – amount distinct from
purchase price, to secure for the buyer the
opportunity to make up their mind.
Leverage amplifies the return on investment (ROI).
The longer the option, the higher the cost because
the seller could’ve sold it; the opportunity cost is
lost, so to compensate, they increase option price.
Call Options
The longer time, the better cause you could
speculate.
Basic Call Option grants its owner the right to buy
a share at a fixed price for a specified period, and at
the end of that time, the option expires and can no
longer be exercised.
An option to buy a stock at a strike price
(underlying stock) sells for the option price.
Underlying stock with increase (buy because
increase will benefit firm).
An option on volatile stock is worth more than one
on a stable issue, because volatile stock price is
likely to go above the strike price in the allotted
time.
People also pay more for options with more time
until expiration, because that gives the stock’s price
more time to move past the strike price.
The Call Option Writer Two parties to an option
contract, a buyer and a seller. Don’t confuse buying
and selling the option contract with buying and
selling the optioned stock. Option originators write
the options. Once it’s written, the option contract
becomes a security and a writer sells it to the first
buyer who may sell it to others.
No matter how many times the option is sold, the
writer remains bound by the contract to sell the
underlying stock to the current option owner at a
strike price if she exercises.
A call option writer hopes the underlying stock
price will remain stable. If it does he will recognize
a gain from the receipt of the option price.
Intrinsic Value It is the difference between the
stock’s current price and the strike price.
Out the money
Strk
If Vic is out of money, Vic is zero. It is when the
stock price is less than strike price.
Vic = Ps – Pstrk
Vic = Intrinsic value of call option
Ps = current price of the underlying stock
Pstrk = the option’s strike price
The price of the option is directly proportional to
the price of the underlying stock.
Option’s Value has a market value.
Time premium is the conversion premium or the
convertible bonds.
The difference between the intrinsic value and the
option price is called the option’s time premium.
Time premium = Pop – Vic
Investors are willing to pay premiums over intrinsic
value for options because of the chance that they
will profit if the underlying stock’s price goes
higher.
Time premium is generally largest when a stock’s
price is near but a little below the option’s strike
price; it diminishes as the stock price rise.
Options and leverage
(financial) Leverage amplifies return on investment
(ROI). Options represent one of a number of
leveraging techniques. Options offer a great deal of
leverage. The option isn’t quite as good a deal when
the stock is trading above the strike price:
1. Stock price has to rise higher to make a given
profit, and
2. The buyer has to pay positive intrinsic value in
addition to the time premium for the option,
which makes his investment larger and
decreases the leverage effect. Options That
Expire Options are exercisable only for a
limited period, and become worthless when
they expire. If an option is purchased out of the
money and the underlying stock’s value never
In the money
exceeds the strike price, the option expires and
the buyer loses the price paid for it.
If an option is purchased at a price that includes
positive intrinsic value and the underlying stock
goes down in value, the option buyer’s loss at
expiration is the time premium plus the decrease in
intrinsic value.
Trading In Options
Options can be bought and sold between investors
at any time until they expire. Options on selected
stocks are traded on a number of exchanges
throughout the country.
Price Volatility in the Options Market Option prices
move up and down with the price of the underlying
securities (strike price) but the relative movement is
greater for options. Option prices move rapidly, and
are rarely exercised until immediately before
expiration because exercising requires throwing
away whatever value is in the time premium. The
Downside and Risk Speculating in options involves
a good chance of total loss. It amplifies both losses
and gains.
Writing Options
People write options for the premium income
received when they’re sold, but option writers give
up whatever profits their buyer makes.
Covered Option – the writer owns the underlying
stock at the time the option is written. You know
the shares you are holding, so when the call option
buyer exercises, the writer must sell at the strike
price (price of the written option).
May shares na hawak si writer, pero nagsulat sya ng
call option na ibebenta nya at a strike price (agreed
price). So if mataas ung current value nung stock na
hawak nya, and the holder of the call option A put buyer profits if the optioned stock’s price
decided to buy the shares na hawak ni writer, may falls.
opportunity loss si writer. Bakit? Kasi if hindi
nagsulat ng option si owner ng shares, kanya ung When the stock is trading above the strike price, the
gain from the share’s increase in market value. E intrinsic value is zero. As with call options, puts sell
kaso nga nagsulat sya tapos binenta nya, so for a time premium over their intrinsic value.
marereceive Nyang income is the strike price while
ang marereceive ni buyer is the current price nung Vip = Pstrk – Ps
stock.
Option Pricing Models
Formulas:
Options, like stocks and bonds, are traded securities
 Intrinsic value = Vic = Ps – Pstrk so it’s logical to ask if a similar pricing model
 Time premium = Pop – Vic exists for them. Models are more difficult for stocks
 Pop (Market price of option) than bonds because it’s hard to express an option’s
 Investment = Ps – Pop value as the present value of a stream of future cash
flows.
Call Owner Exercises:
Market price of stock at the time of exercise Option prices can be estimated using the
xx Black – Scholes Option Pricing model.
Less: Pstrk Variables are used such as:
(xx)  Underlying stock’s current price
(Loss)  Option’s strike price
 Time remaining until the option’s expiration
Naked:  Volatility of the market price of the
Market price of stock at the time of exercise underlying stock
xx  Risk – free interest rate
Less: Pstrk xx Warrants
Pop
xx Stock warrant is a contract between a company and
Gain Market price of stock at the time
Covered: an investor giving the investor the right to buy or
xx
of exercise (xx) sell the company stock within a certain time frame
Less: Pstrk xx for a specific price.
Pop xx
Stock Options are second market phenomena,
Gain xx traded between investors and the companies that
issue the underlying stocks are not involved.
Naked Option – writer doesn’t own the underlying Options are secondary market activities and the
stock at the time she writes the option, which puts underlying companies are not involved. Those
her more on risk. Wala pang hawak na shares, companies don’t get any money when options re
mabibili mo palang the moment you exercised. written or exercised.
Risky kasi kung magkano lang bayad sayo (Pop
Warrants are similar to call options but are issued
– strk) yun lang yung kita mo. So if the contract
by the underlying companies themselves. When a
price is lower, and the buyer exercised, if market
warrant is exercised, the company issues a new
prices is high, you could lose.
stock in return for the exercise price. Warrants are
Put Options
primary market instruments.
Is an option to sell at a specified price, simply
called put. Investors buy puts if they think the price Warrants are like options but are issued by
of the underlying security is going to fall. companies which receive equity at exercise.
Warrants are sweeteners attached to other
securities.

Warrants are generally detachable and traded

independently.
Employee Stock Options
They are more like warrants than traded options
because they don’t expire for several years and
strike prices are always set well above current stock
prices. Employees who receive options generally
get less in salary. Stock options are used instead of
a portion of salary.

Employee stock options don’t cost the company

anything in cash when issued.

The Executive Stock Option Problem Senior

executives are the biggest recipients of employee
stock options. Stock options provide an incentive
for executives to misstate financial statements to
keep stock prices up. Misstatements of financial
results uncovered in the early 2000s undermined
confidence in the honesty of corporate
management. The executive stock options system
sets up a conflict of interest that can lead to
dishonest reporting.