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November 12, 2009

Suppose that your company provides you with stock options as part of your compensation. Do you have any idea how much they might be worth?

Sure, you could use the Black-Scholes' method for determining how much your options might be worth, but that will require you to figure out or make a wild guess at things like:

  • The intrinsic value of your options. This is the difference between the current price of a share of your company's stock and the strike price of your option, or rather, the price at which your option allows you to purchase a share of your company's stock.

  • Market volatility over the period of time that you can exercise your stock options. Stock prices go up and down, which makes this factor especially hard to work out.

  • Opportunity costs. If you're considering exercising your stock options, you'll need to have money set aside to actually purchase shares of your company's stock at your option's strike price. That means it's not available to spend or invest, which has a cost. The cost of that money is represented by how much it would cost you to borrow the same amount.

Daniel Sorid has a good discussion on how each of these factors can influence the value of your stock options. And there are some decent tools out there to help you work out the value of your company's stock options [Introduction page here, follow the link for the "Basic Options Calculator", which requires you agree to iVolatility's terms of use before they give you free access to their tool (HT: Fairmark.)]

But what if you just want a ballpark figure to use to estimate the value of your stock options? Without having to guess at how volatile the market will be over the term that the option is good or to work out what your opportunity costs might be?

Basic Investment Information
Input Data Values
Strike Price for Your Stock Options
Number of Shares Covered by Your Stock Options
Period of Time In Which Your Options Are Valid [years]
Expected Annualized Rate of Growth of Stock Price

Value of Stock Options
Calculated Results Values
Estimated Value of Stock Options at Expiration
Dan at Dan and Cheryl's Place came up with a pretty straightforward way to do that, which we've adopted for the math in our tool. He assumes that his company's stock will grow at the historic average rate of growth of the S&P 500 index over the option's holding period. Since the strike price of his employee stock options are set at the market price on the day they're issued, that provides a basic means of approximating the intrinsic value of his options at the time they would expire, assuming the value of the stock grows at the same rate as the stock market itself.

For the S&P 500 and its predecessor indices and component stocks, the average nominal rate of return for the index since January 1871 is 9.4%.

While this approach will give you a general idea of the potential value for your stock options, the biggest downside to this method is that it doesn't take market volatility into account, which can be substantial. For the S&P 500 from 1900 through 2006, during which the index averaged an 11.7% annual return, the standard deviation of its returns is 19.8%.

And that's for the entire index, which is a lot less volatile than individual stocks. Here, the standard deviation of a typical stock between 1994 and 2006 clocks in at 60%.

So what can we do to get a sense of that risk where your employee stock options are concerned?

This is where we get to point you to a great tool. Moneychimp's Volatile Market Simulator can show you what the potential effects of that volatility can do to the value of a $10,000 investment. You can run the tool year by year, or over a 20 year period for either their default stock investing scenario, which assumes 10% annual returns with a standard deviation of 15%, or for a custom scenario, where you can plug in the values for these figures that we've provided above. Since the tool uses a Monte Carlo approach, it will be beneficial to run it several times, specifically over the period covered by your stock options.

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