Black-Scholes Valuations

Intrinsic Value

The value of a vested stock option has two components. One part, called intrinsic value, measures the paper profit (if any) that's built in at the time that the value is determined. For example, if you have an option to purchase stock at $10 per share and the stock is trading at $12, your option has an intrinsic value of $2 per share.

The option has additional value based on the potential for greater profit if you continue to hold the option. This part of the value varies depending on the amount of time until the option expires (among other factors), so it's called the time value of the option. The value of a stock option is the sum of its intrinsic value and its time value.

It is important to understand that option value is not a prediction, or even an estimate of the likely outcome from continuing to hold an option. An option may have a value of $5 per share but end up producing a profit of $25 per share — or no profit at all. Option value is useful information, but it doesn't predict the future.

Graphic Example

The following graph shows the intrinsic value, speculative value, maximum value and actual premium for a call with the following dimensions:

• S = $48
• E = $50
• r = 6%
• sigma = 40%
• T = 3 months

By figuring out the four values (intrinsic value, speculative value, maximum value and actual premium), you can make calculations about the current value of one or more options.

Online Calculators

An attractive alternative to making your own calculation is to use an online calculator available on numerous websites. You can locate these sites by searching for “Black-Scholes Calculator” on any Internet search engine.