We are back speaking with Howard Katz, managing director at Research Capital Corporation, who will be visiting us more regularly as part of The Market Herald Canada’s Investor Series.
Today we’re discussing the value of warrants in the market. Let’s just get to it.
TMH: So two parts of, I guess, the first question here, can you explain to investors what a warrant is and then how can you purchase them?
Katz: Sure, so warrants are really very similar to stock options, whereas a stock option is typically owned by management, warrants are typically owned by investors. When an investor owns a warrant or buys a warrant, that provides them with the right, but not the obligation, to buy that stock or underlying security at a predetermined price for a predetermined period of time.
So for illustrative purposes, for example, let’s say you have a warrant with a strike price of $1 … and it expires in two years. That would mean that for a period of two years, the holder of the warrant can purchase a stock at $1. Hypothetically, for example, and this is just for illustrative purposes, if the stock in question would go to say, $2, and that warrant holder has an exercise price of $1. That means the warrant holder now has the option, but not the obligation, to exercise that warrant and buy that $2 share, that $2 stock, at $1.
In theory, the in-the-money value of that exercise is now worth it to that investor. An incremental $1. It demonstrates a potential area of leverage and return to that investor. Whereas before that was not possible just by buying a stock. So warrants typically offer what we call leverage to investors, enabling them to further increase their returns on an investment in a particular security.
TMH: How does one go about purchasing them?
Katz: So good, great question. So typically, there are really two ways to buy it. But I would say primarily 90 per cent, if not more, of the warrant purchases, are usually bought pursuant to an offering of securities in the marketplace.
So a company would come to market and they would offer instead of saying a share, they would offer their prospective investors a unit. That would mean that a unit is comprised of usually a share and an additional security, which we usually call warrants.
So that would comprise of the unit and so the investor now, when they, for example, if they buy a unit at, say, a price of 75 cents and that comes with, say a $1 warrant, that means that they have bought a unit for 75 cents and an additional warrant that has an exercise price at $1. So that is typically how investors, I would say, in the majority of cases acquire warrants.
TMH: I’ve heard you say before that price isn’t the whole story when it comes to warrants. Can you explain what you mean by that?
Katz: Yeah, it was actually in context to an offering. So, oftentimes investors will be presented with an opportunity to invest in a company. For example, if the unit I mentioned before is being offered at 75 cents and the share price is at 75 cents. Investors sometimes think, well, what’s the deal? Why is there, there’s no deal in it for me. I mean, you know, all things being equal, the share and the unit price are the same. But in fact … the warrants comprising part of the units offer a very valuable incentive and what we do is we value the warrants using a model called Black-Scholes option pricing model.
Just for illustrative purposes; if, for example, that warrant now valued using the Black-Scholes option pricing model is, say, worth 5 cents. So that 75-cent unit is really being offered at a net value of 70 cents because the unit price is 75 cents, the warrant is valued at 5 cents, and they’re getting it effectively for free. That translates into a five-cent further discount on the unit price. So effectively the net price of that offer is now 70 cents. So, if the shares are trading at 75 cents. And they’re being offered net at 70 cents, which effectively translates into a further discount of 5 cents.
So the warrants can act as a very strong source of financial incentive to be considered in the context of financing again, also taking into consideration additional variables as well.
TMH: Do you have any closing thoughts for investors on how they should consider the value of warrants in their portfolios? I’m guessing yes.
Katz: Yeah, warrants can have a very strong potential to create leverage in one’s portfolio. So in other words, what I mean by that is that if you buy a unit and, the share price appreciates, having warrants in your portfolio can, can further add additional profits to one’s portfolio. And we refer to that typically as leverage.
I think it’s, you know, important to monitor one’s portfolio if one does create a portfolio of active warrants because the underlying securities can be volatile and so it’s important to just be on top of one’s portfolio and, and make sure that they’re managing it carefully.
I think just broadly speaking, it’s always a good idea to discuss these types of investment options with an investment advisor. One who’s knowledgeable in this area of investments, and if one of the people in the audience here don’t have one that they can speak to, we’d be certainly happy to refer them to someone at Research Capital.
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