Page 108 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 3: Introduction to Security Analysis

3.8 Warrant Valuation Notes

A warrant is a security that entitles the holder to buy stock of the company that issued it at a
specified price, which is usually higher than the stock price at time of issue. It can be used to
enhance the yield of the bond, and make them more attractive to potential buyers. Warrants can
also be used in private equity deals. Any outstanding warrants must be considered when valuing
the equity of the firm.
There are various methods (models) of evaluation available to value warrants theoretically,
including the Black-Scholes evaluation model. However, it is important to have some
understanding of the various influences on warrant prices. The market value of a warrant can be
divided into two components:
1. Intrinsic value: This is simply the difference between the exercise (strike) price and the
underlying stock price. Warrants are also referred to as in-the-money or out-of-the-money,
depending on where the current asset price is in relation to the warrant’s exercise price.
Thus, for instance, for call warrants, if the stock price is below the strike price, the warrant
has no intrinsic value (only time value - to be explained shortly). If the stock price is above
the strike, the warrant has intrinsic value and is said to be in-the-money.
2. Time value: Time value can be considered as the value of the continuing exposure to the
movement in the underlying security that the warrant provides. Time value declines as
the expiry of the warrant gets closer. This erosion of time value is called time decay. It is
not constant, but increases rapidly towards expiry. A warrant’s time value is affected by
the following factors:
(a) Time to expiry: The longer the time to expiry, the greater the time value of the
warrant. This is because the price of the underlying asset has a greater probability of
moving in-the-money which makes the warrant more valuable.
(b) Volatility: The more volatile the underlying instrument, the higher the price of the
warrant will be (as the warrant is more likely to end up in-the-money).
(c) Dividends: To include the factor of receiving dividends depends on if the holder of
the warrant is permitted to receive dividends from the underlying asset.

(d) Interest rates: An increase in interest rates will lead to more expensive call warrants
and cheaper put warrants. The level of interest rates reflects the opportunity cost of
capital.

Valuation Calculation

Once the free cash flow and WACC are known, the valuation calculation can be made. If the free
cash flow is equally distributed across the year, an adjustment is necessary to shift the year-end
cash flows to mid-year. This adjustment is performed by shifting the cash flow by one-half of a
1/2
year by multiplying the valuation by (1 + WACC) .
The enterprise value includes the value of any outstanding warrants. The value of the warrants
must be subtracted from the enterprise value to calculate the equity value. This result is divided
by the current number of outstanding shares to yield the per share equity value.

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