How to Distinguish Between the Intrinsic Value & the Fair Value of an Option
Original post by Wilhelm Schnotz of Demand Media
When you purchase a stock on the open market, you pay the prevailing price per share to purchase it, and its value is determined in a straightforward market-driven manner. Stock options have a more slippery and conceptual notion when determining their value, because their price hinges on the option price when granted as well as the open-market price. Investors and companies use two methods, intrinsic value and fair value, to price options. Because an option’s reported value can differ greatly depending upon what method determines it, investors should understand the two valuation methods when investigating any stock option purchases or financials when a company reports outstanding options.
Determining Fair Value of Options
Locate the market price of the stock on the day the option was issued using historical stock data. For example, Mr. Smith received options to purchase 500 shares of stock at $10 a share on a date when shares traded for $20 each, so the market price is $20 per share.
Determine the number of optionable shares available. In the example, Mr. Smith owns 500 shares.
Multiply the market price of the stock at the option’s issue date by the number of optionable shares to determine fair value. Mr. Smith’s options’ fair value is $10,000.
Determining Intrinsic Value of Options
Locate the excise price listed in the option agreement that specifies the preferred price an option holder can purchase stock. Continuing the example from above, Mr. Smith’s option price is $10 per share for his 500 optionable shares. Market prices on the date options were issued are irrelevant when determining intrinsic value.
Determine the stock’s current open market price. By the time Mr. Smith’s options mature, the company’s stock trades at $23 per share. Multiply the open market price by the number of optionable shares. In this case, the stock’s open market value is $11,500.
Determine the amount necessary to exercise the stock option at option prices by multiplying the option price by the number of optionable shares. For Mr. Smith, it’s $5,000, or $10 x 500 shares.
Subtract the excise price from the current market price. The intrinsic value of Mr. Smith’s options are $6,500, or $11,500 – $5,000.
Tips & Warnings
- The fair valuation of a stock option is concrete and doesn’t fluctuate with the stock’s current price because it’s based on historical data. The intrinsic value of an option is fluid, however, because it’s a function of the latest market price for the stock.
- University of Texas El Paso: Share Based Compensation Plans
- Tulane University: Options
- Trader Soft: Option Price = Intrinsic Value + Time Value
About the Author
Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including "TV Guide" and "The Dallas Observer." Schnotz holds a Bachelor of Arts in journalism from Colorado State University.