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On August 25, 2011, Bank of America announced the sale of $5 billion of 6% Cumulative Perpetual Preferred Stock to Berkshire Hathaway. The preferred stock is redeemable by Bank of America at any time at a 5 per cent premium.In conjunction with this agreement, Berkshire also received warrants to purchase 700,000,000 shares of Bank of America common stock at an exercise price of $7.14 per share. The warrants may be exercised in whole or in part at any time, and from time to time, during their 10-year life.
At Bank of America’s closing price of $6.87 per share on January 11, 2012, what are these warrants worth? Although these warrants are currently “out of the money” since the underlying common shares are selling below the strike price of $7.14, they have considerable value which can be estimated using a Black-Scholes calculator.
When applying a strike price of $7.14, stock price of $6.87, time remaining of 3520 days, historical volatility of 59% (source: TD Ameritrade), and a risk free interest rate of 2% (10-year U.S. Treasury), each warrant is valued at $4.59. Therefore, Berkshire’s 700,000,000 warrants have a total current value of approximately $3.2 billion.
Warren Buffett’s $5 billion investment in Bank of America’s 6% preferred stock is not only earning $300 million per year in dividends, but has also added $3.2 billion in shareholder value from the 700 million warrants that it has acquired.
It is interesting to note, that in The Government Employees Insurance Company’s third quarter 2011 filing with the National Association of Insurance Commissioners, this Berkshire subsidiary showed that it had acquired 229.6 million Bank of America warrants at a cost of $328.0 million, or $1.43 per warrant on September 1, 2011. Using Bank of America’s closing price of $7.89 on September 1, each warrant would have had a value at that time of $5.52. Therefore, it appears that Berkshire had used very conservative accounting and assigned a total value to its Bank of America warrants of $1.0 billion.
Many discussions of Berkshire’s $5 billion investment in Bank of America omit a valuation of the warrants since they are currently out of the money. However, these warrants have added considerable value to Berkshire Hathaway.
This post originally appeared at Dr. David Kass’ blog dedicated to Warren Buffett and Berkshire Hathaway