Friday, September 30, 2011

Warren Buffett didn't make 20% on August 26th...

...he potentially made over 63%!

And his investment is asymmetrically depended on the performance of the Bank of America shares. He can gain when shares go up, but doesn't lose when they go down. Unless the bank fails.

How does it works?

Chart: Bank of America, 3M, 2011-09-30;

Bank of America is down again today. So far -2.6% at $6.18. That's 11.6% below the price on the day when Warren Buffett invested $5 billion in the company ($6.99), and 16.6% below the strike price of warrants granted to him ($7.14).

Nevertheless, one cannot say that Mr. Buffett is down on his investment.

The Buffett's investment consists of two elements:

  • preferred shares paying 6% dividend
  • 10 years warrants for 700 million BofA shares with the exercise price of $7.14

Preferred shares are more like a subordinate debt rather than ordinary shares. Their performance is not connected with market fluctuations. As long as BofA don't go bust, they pay a nice dividend and retain their value.

Warrants are equivalent of call options on BofA shares. Based on the historic 10 years BofA volatility of 55% and using 10 year T-bonds yield of 1.83% we can estimate the value of the warrants using Black-Scholes formula. The result is $4.5 per warrant.

Since Bank of America granted 700 million warrants to Mr. Buffett, the potential value of them is about $3.15 billion. $3.15 billion on top of $5 billion investment makes a 63% return.

There are two critical assumptions in this investment, though:
  1. Bank of America does not go bankrupt
  2. Bank of America does not require a substantial government bail-out that wipes out existing shareholders and decimates share price
Even if you assume a high discount rate (say 50%) for calculating the potential value of the preferred shares purchased by Buffett, the total ROI on investment is above 10%.

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