Your Company Stock Options
Having an Exercise Plan that’s Right for You
This article represents the views and opinions of Brightworth and has not been reviewed or endorsed by your company or any of its employees. © 2020 Brightworth. All rights reserved.
As a seasoned corporate executive, the gain in your stock options may be one of the largest assets on your balance sheet. This means that a large part of your overall net worth is tied to your company’s stock price (in addition to your salary, annual incentive bonus, and benefits). One of the most common questions we address for our corporate executive and professional clients is: “When should I exercise my stock options?”
Not only is this a valid question, it can be one of the most important questions you should be asking. In our experience, by the time people seek professional guidance on this critical topic, they’ve usually already received “advice” from their co-workers around the water cooler or from their internet search results. On the surface, the answer to when you should exercise your stock options is actually quite simple. The answer is: it depends. Practically the answer is much more complicated. It dually depends on the implied value relative to your company’s current stock price and your unique personal and financial situation.
While many hope to exercise and sell options at the highest price possible, no one has a crystal ball, and it is exceedingly difficult (if not impossible) to consistently predict the short-term movements of a single stock. With this acknowledged realization in mind, there are a few tried and true techniques that can assist investors as they strategize when to exercise options. These methods include the Black-Scholes Formula, analyst reports, valuations, and market-level factors.
Developed in 1973 by economists Fischer Black, Myron Scholes, and Robert Merton, the Black-Scholes formula seeks to value stock options using five inputs. Scholes and Merton won the 1997 Nobel Prize in Economic Sciences for their work on the formula.
Three of the five inputs (current stock price, stock option exercise or strike price, and stock option expiration date) should be readily available on your stock option statement. The fourth input, the risk-free interest rate, is historically often measured by the current interest rate on three-month U.S. Treasury Bills, but other rates are sometimes substituted in today’s historically low interest rate environment. The fifth input, the annualized volatility of the stock, is typically taken from the stock’s standard deviation over the preceding ten years.
With these inputs, the formula calculates the implied value of the stock option at its date of expiration. For example, the formula may calculate an implied value of $7. If the stock option’s exercise price is $38, that means the formula predicts that the stock is likely to be trading at $45 (or $38 + $7) at the option’s date of expiration. Many take this implied price and make it their “trigger price” to consider exercising and selling their options.
It is worth noting that this implied trigger price will always be higher than the current stock price. So, if the stock gets to $45 and you re-run the Black-Scholes formula, you will get a new, higher implied trigger price. Sadly, as we have seen time and time again with executives who frequently call brokers where their stock options are custodied to inquire about the latest Black-Scholes trigger price, this can paralyze investors and cause them to continuously and dangerously delay exercising their options until it becomes closer and closer to their expiration date. You can see this output in the graph above, where the blue line is the current stock price and the gold line is the implied price that the Black-Scholes formula recommends exercising the option at.
*See assumptions and notes at the end of these materials
Given this limitation, we recommend running the formula shortly after receiving the stock option grant, and then utilizing it as only one factor for deciding when to actually exercise and sell. We do not recommend constantly rerunning the formula as the stock price appreciates, because you’ll be repetitively raising the implied trigger price and the formula will never actually tell you to exercise.
The formula has several other limitations including assumptions that interest rates and volatility are constant, no dividends are received, returns follow a lognormal distribution, and that the stock options can only be exercised at expiration. If interested in using this formula to help partially guide your stock option exercise strategy, we recommend speaking with a wealth advisor who can help you run the calculations and interpret the results.
Many well-known companies are followed closely by research analysts at financial institutions around the world. These analysts dig through company financials, listen in on shareholder calls, and research competitors. With this information, they put together reports that include write ups about company strategy and price targets for how much the stock may be worth at a given date in the future. The price targets will vary based on the analyst writing the report. Some may be optimistic and others pessimistic. Instead of using just one analyst report, we recommend looking at many and planning to average out the price targets. While analyst reports can be interesting and informative, they are also by no means a perfect predictor of future stock performance.
A price-to-earnings or “P/E” ratio is a common measure for determining how highly a stock is valued. The formula is straightforward. It is the price per share over the earnings per share. For example, if the stock price is $50, and the company earns $2 per share, the P/E ratio is 25. A high P/E ratio indicates that shareholders are currently paying a high price relative to the company’s current earnings. They may be willing to pay a premium because they expect the company’s earnings will grow quickly over time. Conversely, a low P/E ratio indicates that investors are paying a low price for current earnings and may be less optimistic about the future growth prospects of the company.
Generally speaking, investors prefer to hold onto their options when the company is valued low (i.e. a low P/E ratio) and they prefer to exercise and sell options when the company is highly valued (i.e. a high P/E ratio). That said, determining whether a P/E ratio is high or low requires context. This context can come from looking at P/E ratios for industry peers, seeing how the company’s P/E ratio has changed over time, and also normalizing the P/E ratio for one-off events (i.e. mergers, acquisitions, and restructuring).
You may have heard the phrase “a rising tide lifts all boats.” Similarly, a rising market can lift many stock prices and a falling market can lower stock prices. It is important to consider the risks and opportunities within the current market environment as a part of your stock option plan. If you are in the midst of a long bull market with high valuations and geopolitical concerns, it may make sense to proactively exercise and sell options earlier, instead of holding out for a potentially higher price. Conversely, if the market has low valuations and the economy is beginning to hit on all cylinders, it may make sense to hold onto your stock options a little longer than you otherwise would in hopes that they’ll appreciate with a rising market.
Your Own Unique Situation
While it would often be optimal to exercise and sell your options at the highest stock price between the vested date and expiration date, that may not be best for you. If your options are already “in the money” and you have some sizable gains, consider prudently taking some or all of the gains off the table well before the expiration date if:
- Your stock options have generated enough gain to provide for a specific cash flow need such as paying for your child’s college, renovating your kitchen, or paying off your mortgage.
- Your stock options have generated enough gain to secure your financial independence in retirement assuming you exercise your options and reinvest the proceeds in a prudently diversified portfolio.
- This is an abnormally low tax year for you. For example, you are often in the 32% Federal Tax bracket or higher, but due to other factors your income is expected to be less this year. Now, you can partially or totally exercise an option and fill up the 24% Federal Tax bracket. Certain tax savings can be as/more valuable than speculative future stock price appreciation. However, in most cases exercising stock options at a higher price and paying more tax is better than exercising at a lower price and paying less tax. Don’t avoid exercising stock options because you don’t want to pay tax. Paying tax means you have made money! There are many strategies to minimize the overall tax bite which should be part of your financial planning strategy.
- You believe your company’s stock price will be flat or lower between now and when your stock options expire, and the stock option proceeds could be more strategically reinvested.
- To minimize personal risk, you would like to reduce your concentration and total investment allocation in your company’s stock.
These reasons and more are why it may make sense for two people who work at the same company with the same option grants to exercise their options at different times. When trying to decide when to exercise and sell options, current versus future stock price certainly matters, but your personal and financial situation matters, too - maybe even more!
Dually understanding the ins and outs of your stock options and your personal and financial situation is critical to making wise decisions and maximizing value. Having a wealth advisor who has knowledge and experience dealing with stock options, and who truly understands your unique goals and objectives can provide you with confidence and peace of mind when you are trying to determine when you should exercise your stock options and what you should do with the proceeds.
Who Is Brightworth?
Brightworth is a nationally recognized, fee-only wealth management firm with offices in Atlanta, GA and Charlotte, NC. The wealth advisors at Brightworth have deep expertise across the financial disciplines, allowing us to provide ongoing, comprehensive financial advice to families across the country.
*The stock option exercise chart assumes a $38 exercise price, 3 years to expiration, 15% annualized volatility, and a 3% annual risk-free interest rate. These assumptions are hypothetical and do not represent a specific security or actual investment. Investment returns are not guaranteed and the variables of the Black-Scholes formula are subject to change. This information was derived from sources believed to be factual and reliable. It is being provided for educational purposes only and is not intended to be specific tax or planning advice. Please work with a financial professional to develop a stock option exercise strategy that is specific to your situation.
This information is provided as a guide to assist you in your financial planning. Examples are provided for illustration purposes only and are not representative of specific tax or investment advice. Please consult with a professional for specific questions regarding your particular situation.