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Bank of America - common stock vs TARP warrants



January 02, 2011 – Comments (0) | RELATED TICKERS: BAC

The U.S. Treasury received warrants in many big banks in exchange for bailing them out. A warrant is a long-dated call option that gives the holder the right to purchase a stock at a certain price. With call options, I generally prefer to get options as long dated as possible to give an idea time to work out. Most of the options listed on the exchanges go out two to three years at maximum, and on smaller stocks, one might only be able to get options dated 6 months to one year out.

I currently own a batch of Wells Fargo TARP warrants. I expect these to do quite well over the next few years. In fact, I believe that they will do better than the common stock.

I figure the math as follows. You'll need to know basic finance for this to make sense; you can enter the equations in a financial calculator or in Excel.

Wells is trading at $30.99 right now. I figure that the stock is worth around $40. I apply a discount rate of 10%, which is what I typically use for US large caps. In 8 years when the warrants expire, the stock will be worth about $76 - assuming nothing blows up again. That translates to a 28% annualized return. In a financial calculator, plug in the warrant's current price as the present value, 8 years or so (actually 2,500 days or so) as the N, 0 as the payment and $76 minus the warrant price as the future value. That's a superior value compared to the common stock.

In contrast, applying that calculation to Bank of America's  Series A warrant, which is struck at $13.30 and trading at $7 or so, gets me an estimated annualized return of 24%. I figure the stock is worth $21. The stock itself actually produces a higher expected annualized return.

However, there's a Series B preferred, struck at $30.79. If you have faith that BAC's value will compound, then it should be worth north of $40 by the time the warrant expires. That warrant is trading under $3, so one could just take a hail Mary pass with a small portion of one's portfolio. You would be betting that BAC's intrinsic value actually appreciates, and that the stock price will converge with the bank's intrinsic value. That's not an unreasonable bet, and certainly you won't get call options dated this long on a regular basis. However, BAC is the second most troubled big bank, in my mind. This does give me pause.

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