The value of a stock warrant can be based on many things, but the starting point for any valuation is the warrant terms. The warrant terms should be used to define a ballpark valuation, but the final valuation of a warrant should be based on much more than simply the terms.
While a common stock can be valued in a wide variety of ways, cash flow, earnings, growth rate, etc. a warrant will have a strike price and expiration date that provide a jumping off point for valuation. If a warrant has a strike price of $5 (so that you may provide the common stock issuer with a warrant and $5 and they will give you back one share of common stock) then where the common stock is trading will give you an idea of the value of the warrant. In this example, if the common stock is trading at $10 the warrant has a value of $5. But, as we said, this is just the jumping off point.
The warrant will also have an expiration date. This is the date upon which the warrant will become worthless (if you send the issuer a warrant and $5 after it expires they’ll just send you’re $5 back, if you’re lucky). If you’ve traded or are familiar with options, you know that a warrant, like an option, also has time value. In general, the longer the time until expiration the greater the time value.
Continuing with the example above, if our warrant expires in three years it may have another dollar of value in addition to the exercise value. So if the common is trading at $10 our warrant with an exercise price of $5, and three years until expiration, may actually be trading at $6.
If one year from now the common stock is still trading at $10 the warrant may be trading at $5.50. The time decay will not be linear, and just as with an option, the time decay (decreasing value of the time associated with the warrant), will accelerate the closer the warrant comes to its expiration date.
Now that we’ve jumped off, using the strike price and expiration date, what makes the $6 valuation (a warrant with a strike price of $5, common trading at $10, three years until warrant expiration) a good value or too expensive? There are several factors to examine at this point:
- How volatile is the common stock, the more volatile the stock, the greater the value of the warrant
- What is the value of the warrant in relation to options with similar terms that are trading on the underlying common, there may be an arbitrage opportunity here
- Does the company have news pending, such as a litigation claim pending, a drug that is close to receiving approval, etc.; impending news items may impact the value of the warrant
- Whether or not the warrant is exercisable will have a large impact on the value of the warrant
All of these factors should be taken into consideration when valuing the warrant, but often the market price of a warrant will not reflect these additional nuances. Warrants can be found that are undervalued, or overvalued, just as investors find undervalued and overvalued common stock. Warrants are often traded on small cap and thinly traded common stock, and a thorough examination of both the terms of the warrants, and the circumstances surrounding a company, can yield outsized profits for those willing to put the time in to understand stock warrants.