Notice how in the title of this article I said "sound bet." That's because the situation I'm about to describe to you is essentially a calculated statistically advantageous bet. I'm not going to give you any rubbish about what General Motors (GM) does -- instead I'm going to explain why these GM-WTB warrants are extremely undervalued.
For those of you that have no idea what GM does, Hawkinvest, an author on Seeking Alpha, wrote a splendid article about the company. You can read the article here. To further illustrate the attractiveness of this bet, another phenomenal Seeking Alpha author, Adam Jones, wrote about the warrants here.
Now, let's talk warrants. These warrants are essentially call options on GM. GM-WTB warrants expire in July 10, 2019, and have an exercise price of 18.33. As of April 22, 2013, they traded at about 12.76, which gave them a time value of only 1.84. If we take a look at the variables in the Black-Scholes Model (the options pricing model), the fair value should be 14.24.
From these inputs, I calculated the standard deviation of GM by extrapolating the data since its post-bankruptcy IPO, and concluded that the deviation should be 18.18%. The latest risk-free rate was approximately 3% with six years left until expiration. So from a simple Black-Scholes Model the warrants are underpriced by about 18%, while also granting the holder any potential upside from GM's price appreciation.
As of April 22, 2013, GM has a trailing P/E multiple of 9.44, and the forecast forward P/E multiple is supposed to be 6.7. If we take the current trailing P/E and apply it to the forward, we would have a price target of roughly 43.2. By any measures, these estimates are subject to market conditions and macroeconomic factors, but I feel that a P/E ratio of 9.44 still understates the growth prospect of GM. Also, according to Morningstar.com, the PEG ratio is at 0.4, which implies a PEG payback (years) of 3.2.
If the price target of 43.2 comes to fruition, then that would imply a warrant price of 24.875 at its minimum. That's a 95% return on investment.
I am not saying that this will guarantee a positive return on investment, because the underlying performance will still be dependent on GM. However, the prospects of an undervalued warrant coupled with favorable statistical odds make this bet compelling. If GM continues to execute its turnaround strategy, expansion plans, and sound execution, then shareholders will be compensated greatly for taking this risk and warrant holders will be compensated even greater.
In the end, I believe that with a P/E ratio of 9.44 and forward P/E of 6.7, the market has significantly undervalued GM and GM-WTB warrants. This provides investors with the opportunity to exploit this price difference, while also limiting downside exposure.