The Market for Perpetual Options

Given the negative press derivatives have received recently, it appears that the financial world has forgotten that a common stock is actually a financial derivative of the value of the underlying company.

Capital Structure And Derivatives
The market value of a company is simply the sum of the market value of all of the financial obligations of the company: debt obligations, preferred stock, equity obligations, and any other obligations the company issues. The reasoning behind this is simple: if I want to buy a company in its entirety, I need to pay off all of the claim holders in order to have complete claim to the earnings and cash flow generating power of the company.

If the company can't make its payments to debtors, suppliers, or other claimants on the company, the company files for bankruptcy. If the value of the company in bankruptcy is less than the face value of the debt, the equityholders get nothing, and the debtholders get paid all of the value of the company. However, if the company doesn't declare bankruptcy, and the value of the company skyrockets, the debtholders do not participate in the upside of the share price above the face value of the debt.

So if the company value falls below the value of the debt, the debtholders get the company, having paid the value of the debt for it. This is actually the structure of a put option, and buying debt from a company is simply writing a put option on the company. The stock, on the other hand, entitles the stockholder to the value of a company in excess of the value of its debt, therefore stock is a call option on the company value at the value of the debt. However, because a stock does not expire, a common stock is a perpetual call option on the value of a company. This simple example illustrates why I like to think of a call option as the "right to the upside" from a price over a given time horizon, and a put option as "the downside" from a price.

Optionality
Now that we know common stock in a company is a call option, we can better understand how the stock reacts when a company is distressed. During normal market conditions for healthy companies, viewing a stock as an option is just an interesting theoretical exercise, but for companies in distress, the stock starts to exhibit more and more of its optionlike characteristics. In fact, a company when its total value as a going concern is close to the value of the debt exhibits some unique characteristics and is said to display a great deal of "optionality."

To understand optionality, let's run a simple thought experiment. If you buy shares in a stable ongoing company, say  Coca-Cola (KO), you expect the company to always be worth far more than zero, and the company's value is just the value of the cash flows the company will produce over the long term. You wouldn't really weight the probability of bankruptcy in valuing the company, you just make your best estimate of the cash flows, and your expectation for the value of the company in the future is the value of the company today, plus or minus a little bit.

Now, let's say you are betting on the flip of a fair coin. The chance of a coin coming up heads or tails is 50% each, so a fair bet would pay you $2 for every $1 you bet. ($2 times 50%) If you flip the coin once, you get a fair bet, $1. A stock with a 50/50 chance of bankruptcy or being worth $1 should act similarly. You'd be willing to pay a dollar for a 50% chance of $2. The coin bet is an option with a time horizon of one coin flip. There is no chance the bet will be worth $1 after the coin flip, it will be worth either $2 or $0.

The valuation of stocks on the edge of bankruptcy generally work very differently. Since a stock is a call option, it can't go below zero, but there is no theoretical limit to the upside. Consider subprime auto lender  Americredit , which traded below $2 at the beginning of 2003 when the company could not securitize its debt and bankruptcy seemed likely, to over $30 after it made it through the crisis when the economy and capital markets were healthy at the beginning of 2006. The stock price of an option should be the value of all the potential upside outcomes times their probability. Therefore, at $2, the market was likely valuing Americredit as a very high probability of a zero in a short time horizon, but a small probability of a big upside. The bigger the potential upside, the higher the value of the option. The higher the probability of bankruptcy, the lower the value of the option.

Optionality describes the extent to which the upside far exceeds the downside. The challenge with evaluating stocks with high optionality is that many investments with a great deal of optionality will fall to zero value, the volatility is typically extremely high based on nuances of information that might influence survivability, and the beta with the market is typically extremely high as well, given that these companies are typically sensitive to general economic conditions, all of which take intestinal fortitude. However, if you can identify the companies with higher upside potential and lower chance of bankruptcy than Mr. Market is pricing, you can win big by investing in these perpetual options.

Current market conditions have left the market littered with stocks that have a great deal of optionality. These stocks can be viewed as risky, low-batting-average bets that might have great expected returns. More directly, you can think of these companies as "taking a flyer" on what seems like a reasonable bet.

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