During the last 3 days Wells Fargo TARP warrants exploded with 16.6% return, along with the stock, from a price of 8.4$ per warrant to 9.8$.
WFC Warrants present an interesting opportunity since their expiration date is very far from now – October 28th 2018, or over 7 years. Their strike price is 34.01$ – each warrant can be replaced by one stock for 34.01$.
Currently, these warrants cost almost 10$ but their true value, if they should expire today, is zero since the stock is well below the strike price. The current buyer is paying for what is known as the "time value" of the warrant, or in other words he is paying for the chance that the warrant will be worth something at the time of expiration.
I will not get into complex calculations like Black & Scholes or other Warrant / Options valuation models but try to see what does the market believe by pricing the warrants as it does. I will also ignore dividends that could add adjustment to the warrant's strike price if cross a threshold of 34c per quarter.
Let's start from the investor's point of view: Is it better to buy the stock or the warrant?
The answer of course depends on the stock price at the time of expiration. Let's examine the relation between the warrant price and the stock price by some back of the envelope calculations (that I did on the bus today):
= Stock current price
= Stock price at expiration date
= warrant current price
= warrant's price at expiration
= Stock's yield at expiration date
= Warrant's yield at expiration date
Now it is clear that:
And that the warrant's yield will be the warrant's price at expiration divided by the current warrant's price:
Because Warrant's price at the time of expiration will be the stock's price deducted by the strike price.
For an investor to invest at the warrant, his minimum requirement is for the warrant's yield to equal the yield of the stock at expiration. So lets see what should be Wells stock price at expiration as a function of all other values:
Demand yields from warrant and stock to be equal:
If we use: and we get that the stock price at expiration should be 51.19$ for the investor to be indifferent between the stock and the warrant.
Now what does it tell us?
It means that if the stock will yield 75.7% in the next 7 years, investing in the warrant will equal to investing in the stock.
There are a little over 7 years for the stock to reach 51.19$, so the market expects Wells Fargo to yield 8% per year.
Considering that Wells equity is worth about 136 B$ and current market valuation is 13% above this number, and that wells achieves 10.6% yield on equity and distributes about 1.8% of that as dividends, we get that warrants are priced as if wells will earn this kind of yield on equity for the next 7 years and keep current valuation of 13% above book.
But what will happen if Wells will earn more money as it will loan more money? or if it will earn more than 10% on equity? or if the dividend will grow sufficiently to "fix" the warrant exercise price downwards? or if the current buyback program will be expanded significantly?
Some points to consider:
Consider 2005 for example, Wells was worth 103 B$, equity was 40.66B$, a multiple of 2.5 on books, more than double the valuation today. P/E at 2005 was 13.4 (no adjustments). This means almost 20% yield on equity.
From the end of 2000 till the end of 2005 profit rose by 90%, a 5 year only stretch that included a big recession.
Today's P/E is only 10 times 2011's first half extrapolated profits (no adjustments). But today's profits also include many other temporary charges like the Wachovia merger charges and above average loan writedowns, so the actual P/E is much lower. It also does not include the fact that Wells can dramatically enlarge its loan portfolio.
Considering these simple points, it seems very likely that in the next 7 years Wells' stock will achieve much more than 75.7% yield, which makes the warrants an attractive investment.
In case Wells' stock will rise a little more, for example, by 90% (will reach 55.4$), the yield on warrants will be 119% or an average of 11.3% per year.
For the warrants to yield 15% per year as Buffett likes to demand – we get a total of 177% yield for a 7.3 year stretch or a price for warrants at expiration of 27.1$. This implies stock price of 61.1$, which in turn implies that the stock will yield 109% in the next 7.3 years (10.6% per year), and as we saw in the past, it is more than possible.
You can see all of this graphically here.