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When a high quality company trades at a discount, you better take advantage of that usually short-lived opportunity. In the case of American International Group, Inc. (NYSE:AIG), there are several ways to play this rare situation. Other than simply purchasing common stock outright, another alternative exists: purchasing stock warrants. Warrants aren't for every investor; they are essentially leveraged derivatives that can offer very lucrative returns under the right circumstances, but with enough bad luck and equally bad timing, you could be walking home empty handed.

Background On AIG Warrants

AIG warrants were issued as a special dividend to holders of AIG common stock on January 19, 2011 as part of the Treasury's plan to help recapitalize the company. Shareholders received 0.533933 warrants per share of common stock held. The warrants endure for 10 years from the date of issuance; the expiration date is January 19, 2021. The current strike price for AIG warrants is $45, and is adjusted down for any dividends in aggregate that exceed $0.675 within a 12 month period. The warrants are listed on the NYSE under the symbol (AIGWS).

AIG Common Stock

The value AIG stock warrants is entirely dependent on the price of the underlying security: AIG common stock. So let's take a second to evaluate AIG common stock.

Currently AIG is trading at $46.54, which is just 2.5% shy of its 52 week high of $47.68, but still a healthy 31% shy of its post-recession high of $61, which the stock hit in January of 2011.

To properly value insurance companies, an important metric to look at is the company's book value. In the table below I compare the book values of AIG to those of P&C insurance peer, The Hartford Financial Services Group, Inc. (NYSE:HIG).

 1Q131Q12YoY Growth
AIG$67.41$57.6816.9%
HIG$46.78$46.99(0.45%)

Another important metric used to value insurance companies is book value excluding Accumulated Other Comprehensive Income (AOCI). This metric is used to value a company while excluding non-cash items, such as investments, that can fluctuate over time. In the following table you'll find much more conservative numbers for these companies.

 1Q131Q12YoY Growth
AIG$59.39$53.8510.3%
HIG$42.99$43.98(2.25%)

With such attractive book value growth rates you can begin to see the value in AIG, especially when considering that the company trades at a steeply discounted 0.69x book value, and 0.78x book value excluding AOCI.

Potential Warrant Returns

AIG stock warrants are currently trading at $19.01, which may seem steep considering that AIG common stock is only trading 3.4% above the $45 strike price. The warrant premium is $17.47; this means that if you were to purchase AIG common shares via stock warrants, you'd be paying $17.47 more than you would by purchasing the common shares outright. This discrepancy can mainly be attributed to the time premium that's built into warrants, so essentially you are betting that AIG common stock increases more than $17.47 (37.5%) by the expiration date.

Now it's time to make some assumptions. In the table below, I calculate the returns of the warrants relative to returns of the common shares until the time of expiration, January 19, 2021, which is in 7.49 years. I assume that no dividends will be paid, which is a very conservative assumption.

 AIG CommonAIG Warrants
Stock Price$46.54---
Warrant Price---$19.01
Book Value Per Share$67.41---
Price if stock trades at 1x BV w/ 5% annual growth rate in BV$97.15$52.15
Return108.8%174.3%
Price if stock trades at 1.5x BV w/ 5% annual growth rate in BV$145.73$100.73
Return213.1%429.9%

Price if stock trades at 1x BV w/ 7.5% annual growth rate in BV

$115.87$70.87
Return148.9%272.8%
Price if stock trades at 1.5x BV w/ 7.5% annual growth rate in BV$173.81$128.81
Return273.5%577.6%
Price if stock trades at 1x BV w/ 10% annual growth rate in BV$137.64$92.64
Return195.7%387.3%
Price if stock trades at 1.5x BV w/ 10% annual growth rate in BV$206.46$161.46
Return343.6%749.3%

Compared to returns on the common stock, the warrants seem too good to be true. Of course these calculations are based upon certain assumptions, and more conservative investors should take any excessive signs of optimism with a grain of salt. But for those of us out there who are extremely bullish on the AIG recovery, these warrants seem to be the most lucrative way to play the rebound.

Source: AIG Stock Warrants: The Best Way To Play The Rebound

Additional disclosure: I am long AIG through stock warrants.