What exactly is an option? It is essentially a right to buy without the liability to buy. Every option has an underlying asset. It can either be a stock, an index, a commodity, a debt instrument or even livestock. You can have options on virtually any underlying. That brings us to a larger question. Can equity be seen as an option on the assets of the business? After all, equity shareholders are the proportionate owners of the company. Therefore, the equity share can be seen as an option on the underlying assets of the company. Of course, when we talk of underlying assets here, we are referring to tangible assets like plant, machinery, inventory and land as well as intangible assets like copyrights, trademarks, brand value etc. What does that mean from an investor’s perspective?
Equity as an option
What exactly happens when you buy an equity option? You get the right to buy the stock but do not have the liability to buy the stock. You will exercise the right to buy only if the price is favourable to you. For the privilege you pay a price called the option premium. Your maximum loss can be defined as the total option premium. Under no circumstances can your total loss be more than the price you paid to buy the option.
The same logic can be extended in the case of equities. The price you pay for the stock can be seen as the premium you pay for the right to own the net assets of the company. So the maximum loss you will incur will be the price you paid to acquire the shares. Even if the company becomes bankrupt and defaults on payments to creditors, your total liability will be limited to the cost you paid to acquire these shares. To that extent it becomes like an equity option with your price paid as the premium value of the option. This is because of the principle of limited liability in limited companies wherein even if the company has a negative net worth, the total liability of the shareholder cannot be more than the value of equity paid for the purchase of shares. That value, therefore, acts as a call options premium.
Why is this definition important?
Over the last few months we have seen the RBI classifying 12 high NPA corporate accounts as stressed and recommending urgent resolution for these accounts. Failing the resolution, these companies will be referred to bankruptcy. This is where the entire concept comes in handy. What happens to a firm whose equity value dips below the debt outstanding of the firm. The bottom-line is that such companies still have value which explains why most of these stressed companies like Jaypee and Videocon are still trading at positive values. It represents the ability to buy an option on the assets of the company while limiting the risk to the price paid for the equity share. The concept of equity as an option is extremely important and relevant when we are looking at stressed companies with high levels of debt.
To whom should stressed companies be sold?
This is a dilemma before stressed companies. Should stressed companies be sold to the bankers to whom the companies owe debt? Or should the companies be sold to other buyers who are willing to infuse equity into the company. There are two ways to look at this issue. Firstly, if the debt holders take over the stressed company, then their focus will be more on servicing their debt and therefore growth and risk will go out of the window. The second option is to sell these companies to competitors or equity investors. While this has a better chance of bringing back growth in these stressed companies, it also means that risk gets inordinately rewarded. As equity investors the buyers may be inclined to take larger risks since equity moves in tandem with volatility and risk. Thus greater risk brings greater chance of price appreciation, all the while limiting your risk to the total amount invested. How the RBI addresses this dichotomy remains to be seen.
Valuing equity as an option on the assets of the firm has important implications for stressed firms. At the current juncture it will be surely interesting to see how the RBI addresses this conflict of interest as that will have a strong bearing on the way the resolution process goes through!
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