Valuation Primer - Option Pricing Models

Most of the users on the site have heard of option pricing models (OPM), but most do not know how to use the model. OPMs should be used when you need to value different classes of equity, such as Series A Convertible debt versus Class C common stock. Although each valuation will be different (varying waterfalls, dividends distributed, etc.), I have attached a template model for OPM and will briefly explain how to use it.

The first thing which will be necessary when using the OPM will to know the value of the underlying company. It makes sense, because in order to derive the value of each class of equity, we need to know the value of ALL the equity. In addition, we will need to find the risk free rate, based on how long you think the Company will be around (for example, a company which will probably liquidate in two years should have an expiration of 2 years, a long-term company, perhaps a 20-year treasury). Pull the corresponding treasury rate for the date of the valuation and input the expiration into the input page.

Dividend yield will always be set to zero for purposes of using the OPM. Set the volatility based on an average of a comparable set of publicly traded companies. On the input section, be sure to input the amount of shares outstanding for all equity classes.

Under the distribution of value section, you will want to allocate the from and to’s based on the rights of each equity class. This section is used to show at what point each asset classes share the proceeds of a possible liquidation. Typically, a preferred class will be allocated value prior to common equity. For example, if a preferred equity class receives all proceeds from the sale of the company up to $10,000,000, and the company sells for $5,000,000, common equity will not receive any proceeds and does not have value at that point. You will want to include any dividends which the preferred classes have rights to between now and a liquidation in the to and froms.

Below this, you will enter the percent each class of equity shares between each break point. So for a sale from $0 to $2,500,000, C convertible debt receives all proceeds, any money sold above that goes straight to B, then A, and if the sale is above $15,000,000, all classes share equally for any proceeds above $15,000,000. You will not need to touch the d1 or d2, and if everything is inputted correctly, it should flow down.

A quick check will be to multiply the per share value times the amount of shares outstanding, and summing these up. The total should equal the original underlying value of the company determined in the beginning.

If anyone has any thoughts, finds any errors, or if I skipped anything, let me know.

Attachment Size
OPM WSO.xls 38.5 KB 38.5 KB
 

What if the preferred comes with an 8% PIK dividend (or cash for that matter)? What if different parts of the cap structure get different cash/PIK interest - how do you adjust for that?

 
Dr Joe:
What if the preferred comes with an 8% PIK dividend (or cash for that matter)? What if different parts of the cap structure get different cash/PIK interest - how do you adjust for that?
You should be able to include that in the to and from. You will simply add the dividends through expiration on top of the original breakpoint, if that makes sense?
 
Best Response
valuationGURU:
Dr Joe:
What if the preferred comes with an 8% PIK dividend (or cash for that matter)? What if different parts of the cap structure get different cash/PIK interest - how do you adjust for that?
You should be able to include that in the to and from. You will simply add the dividends through expiration on top of the original breakpoint, if that makes sense?
You are right in the case of a PIK, but cash interest has substantially different risk characteristics than a bullet payment. I suppose you could add in each payment as a separate option but to be accurate but how would you account for the options with earlier expiration (interest payments) triggering default and wiping out the equity holders?
 

An example of a generic and basic question is something like this: "What are the key fundamental assumptions of BSM?" The beauty of a question like this is that it opens the floor for some interesting and rich discussions that can go into as much or as little depth as you like.

As to brainteaser-like ones, there's a plethora of 'em (in fact, I think there's even a few books out there, such as this one: http://www.Amazon.com/Heard-Street-Quantitative-Questions-Interviews/dp/0970055285/ref=sr_1_2?s=books&ie=UTF8&qid=1389190469&sr=1-2).

As an aside, how the heck can I insert a friggin' link in a post? Am I being stupid or is this unnecessarily difficult to do here?

 
Vi:
I have read a few books and feel comfortable enough with the theory behind different option pricing methods, but I want to put it to practice with a "real" model.

If you're comfortable with the theory behind options pricing, putting it into practice is child's play in comparison. Which models are you interested in building out?

"My caddie's chauffeur informs me that a bank is a place where people put money that isn't properly invested."
 

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