Two months ago on 5^th May 2015, Homeritz made the following announcement:

ANNOUNCEMENT: HOMERITZ CORPORATION BERHAD

1) Bonus issue of 100,000,000 new ordinary shares of RM0.20 each in Homeritz Corporation Berhad ("HCB") ("Bonus Shares") to be credited as fully paid-up on the basis of one (1) Bonus Share for every two (2) existing ordinary shares of RM0.20 each held in HCB at 5.00 p.m. on 7 July 2015.

2) Issuance of 50,000,000 free warrants in Homeritz Corporation Berhad ("HCB") ("Warrants") on the basis of one (1) Warrant for every four (4) existing ordinary shares of RM0.20 each in HCB held at 5.00 p.m. on 7 July 2015.

On 2^nd July 2015, just before the ex-date of the exercise, Homeritz closed at RM1.53. What would be the reasonable or theoretical price of Homeritz and its warrants after the ex-date and when the warrants are traded at certain price in the near future?

Generic Formula for Price adjustment

In general, there is no value created before and after the corporate exercise although the share price may change due to various reasons, nothing related to the value of the company. Value simply cannot be created from thin air. Hence the total value of the underlying shares and its warrants should remain the same as argued in this link below.

http://klse.i3investor.com/blogs/kcchongnz/79280.jsp

Here we ignore that more value may be “suddenly” recognised by the investors due to some corporate exercises.

Hence the adjusted share price Pa is shown in equation 1 below. It is noted that for simplicity the warrants are assumed to be converted at the conversion price K. In actual fact, the warrant adjustment may have to be based on an option pricing model (OPM) as shown later.

P = Cum-all Price

Y= Original no. of shares

B = Bonus issues ratio

X = Rights issues ratio

W = warrant ratio wrt. X

Z = Subscription price for rights

K = Conversion price for warrants

We will use Homeritz as an example to explain the notations and work out the theoretical adjusted price after the ex-date. This adjustment is based on the principle that the wealth of the shareholders should remain unchanged prior to and after the corporate exercise, the very basic principle of finance and investment.

Homeritz closed at a cum-price of RM1.53 on 2/7/15 just before the ex-date. If you have 20,000 (Y) shares of Homeritz just before the ex-date. The following are the parameters:

Table 1:

The existing shareholders now has an additional 10000 ordinary shares and 5000 warrants.

Plucking those numbers in the equation 1 above yield an adjusted price Pa of RM1.01.

Homeritz was trading ex-date between RM1.00 and 96 sen on 3^rd July and closed at 97 sen on 7^th July 2015. 

Limitation of the price adjustment formula

In the formula of equation (1) above, it is assumed that all warrants will be converted to the underlying share now with the intrinsic value as the only value. However, the value of the warrant also consists of a time value. The time value of Homeritz warrant of 5 years is a big amount compared to its intrinsic value. Hence the value of warrant is being grossly underestimated in the above equation. As this undervaluation is taken up by the underlying share, the underlying share price should be lower as the sum of the value of the underlying share and its warrants should stay the same theoretically. Hence the lower ex-dated price of the underlying share of 97 sen with respect to the theoretical value of RM1.01 from the above equation is expected.

What is the expected value of Homeritz warrants?

Homeritz closed at 97 sen on 7^th July 2015 and we will use this latest price as the reference price of the underlying share for the Black Scholes option pricing model which you have learned before to estimate the price of its warrants from the link here.

http://klse.i3investor.com/blogs/kcchongnz/71783.jsp

The exercise price of Warrant is 92 sen and the expiry date is 5 years from now. The warrant is hence in-the-money with an intrinsic value of 5 sen (97-92=5).

The time value of Warrant is of a 5 years expiry period is considerable and as we have learned,

Warrant price = Intrinsic value + Time value

Hence the price of Homeritz warrant will likely to be much more than its intrinsic value.

Black Scholes Option Pricing

There are a lot of controversies in the use of this Nobel Prize winning option pricing model which is beyond the scope of discussion here. My opinion is it at least gives you a handle of an estimated value of an option which you can roughly base on, rather than nothing.

With the underlying share price at 97 sen, exercise price of 92 sen, 5 years to maturity, risk-free MGS rate of 4%, dividend of 3 sen a year, and a historical annual volatility of HOMERITZ at 49%, the option value of Warrant is 37 sen.

The annual volatility as measured by the standard deviation of the return of Homeritz for the last one year was computed from the daily return data obtained from Yahoo Finance.

With Homeritz share price at 97 sen and its warrant at 37 sen, the total value ex-dated assuming the original number of Homeritz shares of 10000 is RM15475. This is more than its original value just before the ex-date of RM15300 as shown in Table 2 below:

Table 2: Value of shares before and after ex-date

With some iterations to obtain the value of ex-date value to be the same as before, the price of Homeritz and its warrants is 96 sen and 36.5 sen respectively as shown in Table 3.

Table 3: adjusted price of Homeritz and its warrants

Payoff for warrant

Assuming warrant will be traded at about 37 sen upon listing. What would be the possible payoff for investing in Homeritz warrant before it expires in 5 years with various prices of the underlying share?

Figure 1 above shows if Homeritz share price goes up to RM1.50 before the expiry of the warrants, the warrant could be converted to the underlying share with 92 sen and sold at RM1.50 with a gain of 58 sen, or 57%. The gain will be 327% if Homeritz can go up to RM2.50 within this 5 years. But if Homeritz share price goes down below 92 sen upon expiry of the warrant, there will be a total loss investing in the warrants.

With the underlying share price at 97 sen and the warrant price at 37 sen the premium of investing in Homeritz warrant will be 33% with a gearing of 2.6 times. The theoretical value is made up of 5 sen in intrinsic value and 32 sen in time value. The premium will be considered as reasonable for a warrant which has 5 years before it expires. The gearing of 2.6 times will amplify the gains and loss of the warrant.

Sensitivity Analysis

The annual volatility of Homeritz of 49% for the past one year of which the data was used could be a little high as its price has been volatile and have gone up substantially for the last one year. As the price of warrant depends highly on volatility, the higher the volatility, the higher the warrant value, we may be overestimating the value of its warrants. Hence, it may be good to do a sensitivity analysis.

Figure 2 below shows that the theoretical price of Homeritz warrant with respect to the variation of volatility of Homeritz share price. If the theoretical volatility of Homeritz is reduced to 30% in the future, the warrant is only worth 25 sen. If that is the case, the fair value of the underlying share will be a little more if we follow the principle that the value before and after the exercise is the same.

The above is just a theoretical analysis of the expected price of Homeritz based on Black-Scholes Option Pricing. The other important factor is the demand and supply of the shares traded and the actions of the players in the stock market which may or may not resemble the theoretical value.

So what would be the price of Homeritz when listing later? We will wait and see.

K C Chong (11^th July 2015)