Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.
Stock option warrants are discussed in these chapters. Originally, they were devised as "sweeteners" attached to bonds. Later, the idea was hit upon to use them as compensation for underwriters, promoters and executives. Finally, they evolved into a security to be traded by the general public in the same manner as common stocks.
In a simplified form, an option warrant allows its owner to buy a stock at a fixed price for a given period of time. The authors warn investors that the value of any outstanding options of a company represent real claims against shareholder value, and as such should be directly subtracted from the equity value of the company.
As an example, an option with a strike price of $5 (i.e. the holder may purchase one share for $5) may be granted to management as compensation. Even if the share price is currently $4 (and therefore the option cannot currently be exercised for profit), the option has some real value, since it may be exercised later should the stock price rise. This option value should be subtracted from the investor's calculation of the equity value of the enterprise, and investors do not appear to recognize this fact.
The authors also argue that during boom times, investment banking firms lose the professionalism they are expected to maintain and essentially steal from their clients. Excessive compensation, often in the form of option warrants, rob shareholders. Options are used as compensation in this regard, since shareholders tend to underestimate their effects.
Finally, investors are warned to be wary of stocks where certain groups have large control without having large ownership stakes. These sorts of schemes are often orchestrated using pyramiding by means of several holding companies. In such situations, those with control do not have as much to lose as the other shareholders, and as a consequence this will lead to managerial policies which are not aligned with shareholders not holding control.
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