Technicals: Accounting for Income Tax on Bonus Options

According to ボーイフレンド one very important factor in investing where there is very little coverage for its significance is the implications of taxation and the role it plays in our decision making. I believe this to be true. As someone who has spent over twelve months of their life studying income tax in my tertiary studies, it is a subject that I try very hard to block out of my memory, but remains an unavoidable area of life. Unfortunately it keeps catching up with me, even moreso since I've started investing. So when he posed me a question a few weeks ago pertaining to the Capital Gains Tax (CGT) implications associated with our WGB options, I took it upon myself to dust off my trusty Income Tax Assessment Act (1997) Cth (ITAA) and work out the answer.

"In this world nothing can be said to be certain, except death and taxes"

Capital Gains Tax

It would be of assistance to commence our analysis with a definition of what constitutes CGT which is a tax levied on the sale of a capital asset such as shares or property, the gains (or losses) are the difference between what you get when you sell it compared to when you bought it. Although it is known as CGT and would appear to imply a separate tax regime outright, the gains are actually counted as your income and levied at the marginal income tax rate.

In Australia, since 21 September 1999 there is a 50% CGT discount applied to gains made on capital assets which have been held for longer than 12 months, which is a very important rule in our later calculations.

Although these concepts may seem simple to begin with, it becomes very complicated when we consider it within the context of bonus options. 

Scenario

As mentioned in previous posts, WGB is a share which ボーイフレンド and I have been regularly DCA-ing into during the big crash of 2020. So rather than buying it in a lump sum we have purchased it across multiple months which would in turn affect our eligibility to get the CGT discount. Lets assume our purchases were as follows and run through the options for their tax implications:

Option 1: Sell all the options

If we decided to sell all the options outright immediately this would mean that we would be selling 6614 options at a price of $0.13 per option.

Capital Gain = Selling Price - Cost Base

                    = $0.13 x 6614 - $0

                    = $863.33

However in accordance with the rules pertaining to CGT discount, as it is currently 13 March 2021, there would be 874 options which would be eligible for the discount. 

At a marginal tax rate of 37c your CGT on the exercise of the options would be $746.20 x 0.37 + $113.62 x 0.37 x 0.5 = $297.11

After tax returns being $562.71

Option 2: Exercise all the options, sell the original shares

Given the presumption that we do not intend to add to our total amount of shares held, our next option is to exercise all the options thereby doubling our share holding and then selling our original holdings. If we did this, we would have no CGT on the shares we gained from the options we exercised but we would be paying CGT on our original shares.

Capital Gain = Selling Price - Cost Base

                    = $16,799.78 - $14,000.00

                    = $2,799.78

As mentioned, the earlier purchases would be subject to the CGT discount which means that 874 shares purchased in Jan and Feb 2029 would be eligible.

At a marginal tax rate of 37c the CGT of the exercise would be $2,581.38 x 0.37 + $218.38 x 0.37 x 0.5 = $955.91

After tax returns = $1843.87

This may appear more favourable however the cost base of the 6614 shares we retain will now automatically be $2.54 and the acquisition date will become the date that we exercise our shares i.e. 13 March 2021. This means that we will definitely have to hold on to them for a further 12 months for the CGT discount to kick in. 

Option 3: Exercise all the options, sell the new shares

The third option involves exercising all the options but instead of selling the original shares we held, we sold the new shares. 

As per the ATO website, when options are exercised, the acquisition date of the shares is the date in which the options are exercised. If we exercised the shares today, the cost base of the share would be $2.54 the cost base would also have to include the market value of the option currently, i.e. $0.13.

As such, if we exercised the option and sold the share immediately, we would be incurring a capital loss of （$2.54 - ($2.54 + $0.13)) x 6641 = $863.33

If we applied this loss on another capital gain that we make in the current year (or future years) this would reduce our earnings by the equivalent amount, thereby resulting in a net cash gain of 37c in the dollar, being $319.43.

Although this is a lower figure than the other two, what also needs to be considered is the fact that the shares still retained on hand have a lower cost base but have been held for longer periods of time and will potentially be able to get the CGT discount upon sale.

Conclusion

Based on the above calculations, it appears that the answer is that if the goal were to get a maximum short term gain, Option 2 provides this at a moderate cost of future gains which have yet to be determined. Option 3 appears least favourable of the three and would not be recommended.

Disclaimer: The material on this post (and blog) is provided for general information and educative purposes in summary form on financial topics which is current when it is first published. The content does not constitute legal or financial advice or recommendations and should not be relied upon as such.

Appropriate legal and advice should be obtained in actual situations.

by 小福

Maths : Valuation Models: Discounted Cash Flow and Application to PE Ratio

Within the recent months, those who have mostly invested in Australian stocks such as ボーイフレンド and myself would have seen returns come up mostly flat whilst watching US stocks soar well past their February peaks. 

Stacked atop each other, it is very striking to see the differences in how far the ASX200, S&P500 and NASDAQ have performed since the March crash. If you had invested in NASDAQ at the start of the year, you would currently be up 31.7% whilst you would still be down 12.8% if you were solely in ASX 200. 

For those who have followed the news, it has been apparent that most of the gains made in the US markets are largely attributable to the tech sector. By way of illustration, the following charts show the current year to date return on the ASX, S&P when compared to Tesla, Microsoft, Amazon and Zoom. 

As you would expect from this kind of level of growth, stocks like TSLA, ZM and APPL have dominated a lot of the talking points in quite a few share forums and a few friends have been talking about buying into them lately too. 

As a value investor, whether or not a stock is worth purchasing depends largely on whether it represents good value when considering its growth and return prospects. So this is what we will attempt to discern for the aforementioned stocks by use of the Discounted Cash Flow method for security analysis with specific reference to the current PE ratios of said securities. 

Discounted Cash Flow

Discounted cash flow is a method to calculate the value of an investment based upon the sum of its' total future cash flows and applying net present value of the total of the cash flows. The formula is as follows:

The formula provides a framework to determine what the fair value of the investment is, thereby aiding the determination of whether or not the current pricing is above or below fair value, showing whether or not it is a good buy. 

Usually when calculating DCF, projected cash flows are estimated for the upcoming five years with every year subsequent estimated at the standard 3% being standard GDP growth indefinitely. 

In applying this model, you arrive at a total expected value for the company, which can be divided by the current amount of shares to determine a fair value of the share given it's projected growth (in the next five years). 

Application to PE Ratio

As mentioned earlier, PE ratio is determined by price divided by earnings. This can be utilised by the DCF model to show what the anticipated growth of a company is based on what the PE ratio currently is. 

Without using actual earnings figures, if you assume the first year's earnings to be one and project the next five year's growth and then apply DCF, the resulting figure is the fair PE ratio for anticipated growth. 

By way of example, take the current Australian CAPE ratio, which sits at 17.5 per StarCapital as at 31 August 2020. With an inflation rate of 1.25% and risk free rate of 7.5% it shows that with a PE of 17.5 is fair value if earnings are expected to grow at 3% per year to perpetuity. 

In contrast, we can take a quick look at TSLA, ZM and APPL figures as they are now:

To justify a PE of 1083, Tesla will need to grow at 300% per year for the next five years.

To justify a PE of 472, Zoom would need to grow at 250% per year for the next five years.

To justify a PE of 36.7, Apple needs to grow at 25% per year for the next five years.

The question then as to whether or not these securities are worth purchasing depends on whether the investor considers the expected growth to be in line with the potential growth of the company. In looking at the above three companies, it would not be unfair to say that TSLA and ZM are very unlikely to be able to achieve the growth required to justify their PE ratio, whereas it could be plausible that APPL could achieve it. Given the uncertainties surrounding the tech sector though, these are still not securities that I would really be in a rush to purchase.

by 小福

Maths: On maintaining or increasing dollar cost average

Have taken a short hiatus since my last post. With the February March crash well and truly behind us, the last two months in the market have been extremely flat. Long gone are the days of extreme volatility and since mid June, not much has really happened. This is clearly evidenced in the below chart:

As I write this, the ASX stands at 6126 points, a good 15% below the all time high of 7199. Although the S&P 500 has since reached all time highs and NASDAQ has long surpassed it, the ASX remains steady at around the 6000 to 6100 mark.

Given what had happened in February and March, ボーイフレンド had been a strong advocate for investing more and more the greater the deviation from all time high. At the bottom of the market, he was putting in 16 times his usual investment amount on a monthly basis, and then gradually scaling back as the market recovered. Where we are now, he is still putting in 4 times the usual, which has obviously impacted on cash reserves. With my limited resources, I am also putting in double what I would normally invest into the market. This has obviously resulted in fairly good returns for the both of us, he has long recouped all losses whereas I am roughly breaking even, even though the local market is still significantly lower than it was.

This brings me to current day, where we have fluctuated around this mark for about two months and I had been pondering whether or not to reduce our contributions given it had been eating into our cash reserves and that some developed countries had opted to go into lockdown again given second wave covid.

Essentially the dilemma I was facing was as follows:

• If I keep contributing a greater amount than usual and the market crashes or suffers a correction due to second round lockdowns or other unforeseen circumstances, the funds I had invested in the market would be hit and I would also have a significantly lower cash reserve to throw into the market to get the benefit of better value shares.
• If I reduced my contribution to my original standard amount, even though the market stands at 15% lower than all time high, and a crash does not occur, the cash I hold in the bank will be making negligible returns and whatever I do not invest now will have to be invested at a later date where the prices may have inflated considerably.

In pondering what to do with this conundrum, he mentioned the utility in working it out via outcome matrix given the range of potential situations and our three variables:

• Increased or standard contribution
• Depth of crash
• Potential of crash

We worked this out using the following simulation. Whilst the current Australian CAPE stands at 19, there was no consideration for us to cash out any of our holdings, which meant at least one less factor. Assumptions we made in the following examples are as follows:

• Standard contribution is $5,000 per month, increased contribution is $10,000 per month
• Where the market doesn't crash, it goes up by the annual amount of 10%
• Starting portfolio is $0 as what is already in the market is irrelevant.

Outcomes of our simulations are as follows:

Allowing for a 40% crash in 3 months

Allowing for a 30% crash in 3 months

Allowing for a 20% crash in 3 months

From the results, it can be easily distilled that the lower the chance of a crash, the better it is to go in with a higher contribution so as to maximize returns on cash. By putting these numbers into the matrices provides a quantifiable outcome for either scenario, thereby allowing me to consider which course of action I ought to take.

With the Australian Market pricing in zero profits across the board for the future year and a half (using CAPM and DCF models given risk free rates), it is fairly safe to say that the odds of a significant correction in the market is lower than usual, provided a Republican win in the Presidential Election in USA. Given the above modelling definitively shows that there is a strong reason to continue to contribute aggressively to the market whilst prices are still at their current rates.

by 小福

Maths: Greek

In the course of my reading what I consider to be fairly technical financial reports and analyses, I often come across references to Greek. Having covered them briefly in the finance courses of my commerce degree years ago, I thought that it would be a good time for a slight refresher on what I already know in addition to learning things whilst providing a reference guide for the future. 

The first two Greeks that I'll discuss relate to the broader notions of investing and have a fairly wide range of applicability while the remaining deal specifically with options.

Risk Ratios

Alpha

Alpha is defined as excess return on investment when compared to an indexed benchmark. Therefore alpha is calculated as actual rate of return less benchmark rate of return. The resulting figure gives an indicator of whether the investment over-performed (if the number is positive) or if it under-performed (if the number is negative), essentially providing a measure of relative return.
A positive alpha indicates an investment had a good return given it's underlying risk whilst a negative alpha indicates the opposite.
When people say they have a high alpha, it means they have a tendency to outperform the market.

Beta

Beta is defined as the measure of relative volatility compared to the market as a whole. It is used to measure systemic risk of a portfolio when compared to the benchmark.
The formula for beta: 
Although it looks fairly complex, it can easily be calculated with excel by using variance and covariance formulas.
By definition, the market as a whole has a beta of 1. A resulting number of less than 1 indicates that it is less volatile than the market which can often be found in lower risk investments such as bonds or gold. A higher beta indicates that it has more volatility than the market. For those who dabble in inverse indices, a negative beta demonstrates that the investment moves in the opposite direction of the market.
High beta vehicles often offer higher returns whereas low beta investments offer lower returns. By utilising the Capital Asset Pricing Model, one can then derive what a fair return on investment ought to be given any beta.
In combining the two, it can therefore be concluded that the most attractive investments are those that offer the highest alpha with a low beta.

Options Greeks

Delta

For those who remember from their high school days, Delta is a measure of change. In the finance context it measures the rate of change of an option with the change in underlying asset's price.
The formula for delta:
The resulting number ranges between -1 to 1 with negative numbers for puts and positive for calls. Delta represents the change in the price of the option for every dollar movement of the share.
Options which are deep In The Money (i.e. calls where the market price > strike price and puts where market price < strike price) will have a delta closer to one whereas options which are deep Out of The Money will have delta closer to zero. In practically applying delta, it is often used as a rough indicator of the probability that the option will expire in the money. A delta of 50 would mean that it has roughly half a chance of profiting by expiry. The higher the delta the more chance you have of profiting, but usually this would correlate to higher premiums for the contracts.

Gamma

Again one from high school mathematics, Gamma represents the derivative, that is rate of change of Delta with respect to the change in the underlying asset's price.
The formula for gamma: 
Simply put, gamma is to delta as acceleration is to speed. Gamma is always positive and highest when the option is closest to At The Money (market price = strike price). It is sometimes called the "Uncertainty Factor" because of this, since when options are closest to  ATM the higher the chances that it could end up either way.
Practical example, if a stock had a value of $100 with the correlating call having a delta of 0.45 and a gamma of 0.05, when the stock goes to $101, the delta becomes 0.50, so the value of the premium goes up correspondingly.

Theta

Theta is a function of measuring an option's time sensitivity. It gives an indication of the change in the value of the contract given a one day change in time.
The formula for theta:
Short options, that is selling contracts, has positive theta whereas long options have negative theta because the closer you get to expiration date, the less the underlying contract is worth because of the lower probability of market value making the required strike price. By way of example, a Theta of -0.10 means that every day that the stock price does not move, the value of each contract will reduce by $0.10. The lower the theta, the slower the rate of decay is on the contract.
For those who browse forums as much as I do, you may have come across the term Theta Gang. Theta gang represents those who sell options to profit from the decay in value when it expires OTM.

Vega

To clarify, Vega is not actually a Greek letter, rather it uses the letter nu, but as the character bore similarities to the letter v, it has been named vega in line with beta and theta. It measures the change in the option's value with every percent change in implied volatility.
The formula for vega: 
All options have a positive vega. When implied volatility is higher, options are worth more as people think that there is a higher likelihood of meeting the required strike price. As such, with the most recent volatility in the market, options would have sold for a far higher premium and as volatility subsides they will be worth considerably less, hence the term IV crush.

Though I have little intention to dabble in options, having a good understanding of the above is always useful when assessing other's option purchases to consider their viability. It's also very interesting to learn on the side anyway.

by 小福