Foxboro–Consulting Group Methodologies For Fair Stock Option Valuation

Let’s begin this article with defining what actually does Stock Option means? Stock option provides the holder the right to sell or buy a given number of shares from the market at a fixed price within the agreed period. The option holder is however not compelled to buy or sell the shares at fixed price and the price he decides on mutual understanding is called strike price. There are two types of options: call options and put options. Call options provide the holder the right to buy a security. Put options, on the other hand, provide the holder the right to sell a security. 

Let’s now focus on some commonly used Stock Option Valuation Methods:

1. Black-Scholes Model 

This is the best known theoretical stock option valuation model that is most widely used for stock valuation. This method is based on partial differential equation that computes the stock option price based on the difference between the adjusted stock price and the adjusted present value exercise price. Adjustments in stock price and exercise price are based on a log normal distribution relationship between the changes in option price relative to the change in stock price. The relationship is called the hedge ratio, which is used to compute the number of options necessary to equate the return on a portfolio for risk-free securities to the return of a portfolio of options and stocks.

It is important to be aware of the underlying assumptions of the Black-Scholes model to avoid misapplication. The assumptions are as follows:

I. The short-term interest rate is known and is constant through time.

II. The stock price follows a random walk in continuous time with a rate of variance in proportion to the square of the stock price.

III. The distribution of possible stock prices at the end of any finite interval is lognormal.

IV. The variance of the rate of return on the stock is constant.

V. The stock pays no dividends and makes no other distributions.

2. Lattice Model

This is more complex than the above model which is based on either binomial or trinomial distribution process to find value by separating the total maturity period of the option into discrete periods. When progressing from one time period, or node, to another, the underlying common stock price is assumed to have an equal probability of increasing and/or decreasing by upward and downward price movements. The lattice model is a more flexible valuation technique that can account for early exercise behavior and various market and performance conditions.

3. Monte Carlo Simulation

This approach simulates share price movements using assumptions of log normally distributed prices, averages the payoff values over the range of resultant outcomes, and then discounts the expected payoff at the risk-free rate to get an estimate of the value of the option. The advantage of Monte Carlo simulation is that it can be used when the payoff depends on the path followed by the underlying common stock value as well as when it depends only on the final value of common stock. Payoffs can occur at several times during the life of the derivative rather than all at the end.

Valuations are needed for stock options issued by both public and nonpublic companies. As the preceding indicates, the issuance and valuation of stock options is very complex. To get your Stock Option Valuation, Consult to the best consultants at Foxboro-Consulting Group,Inc  that provides Valuation and Business advisors. We have Physician practice valuation Consultants, Real Estate Valuation Consultants, Business Valuation Consultants, Litigation Support Service Consultants and many more with best practices and methods to solve your problem. For further details, you may visit our official website http://www.foxboro-consulting.com/.