Buffett's Big Bet: The Real Value of the Berkshire Investment in Goldman Sachs 17 comments
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Warren Buffett has had a lot of success. But I’ve got to hand it to him, this deal has the makings of an absolutely brilliant move.
Last week every major news outlet seemed glad to report Buffett had practically saved the day when Berkshire Hathaway (BRK.A) made a $5 billion investment into Goldman Sachs (GS).
But as details shortly followed we learned Goldman had to bend over backwards to close this deal. Buffett got a lot more than a $5 billion equity stake in Goldman. He also got more than 43 million warrants to buy Goldman shares at $115 and a 10% annual dividend to boot.
When you add everything up, he practically got his position at a 39% discount. The numbers don’t lie.
Warrant Value
Warrants have value. To find that value we have to make a few assumptions.
If we look at the Goldman Sachs Jan 2011 110 call option (which is the closest actively traded security to the warrants), the implied volatility the market assigns to long-term Goldman options is 44%. These options were trading for about $47 a piece and had 839 days until expiration.
Once you up the days until expiration to 1800 to account for the five year life span of the warrants, take Thursday’s closing price of $133, the value of each of Berkshire’s warrants is $60.26 a piece.
That means Berkshires 43.478 million warrants is worth a total of $2.62 billion.
Dividend Value
We’ve also got to account for the value of the $500 million a year in dividends. The Net Present Value of those (discounted at a 10% rate) are worth $1.96 billion if it Berkshire holds them for five years.
Preferred Share Value
Finally, we’ve got to take the value of the preferred shares. Goldman has to buy these back at some time or they will be an annual $500 million drain on its annual cash flow and pre-tax profits.
The value of these will fluctuate with general interest rate levels and Goldman’s creditworthiness so it’s tough to put a value on these. But if we take an 8% discount rate, the present value of a $5.5 billion repayment from Goldman in five years (as part of the deal, Goldman has to pay a 10% penalty for buying back the preferred shares) is $3.62 billion.
Total Deal Value
If you add it all up, Berkshire is walking away with $8.2 billion for its $5 billion cash infusion. That’s equivalent to buying dollars for 61 cents each.
Of course, we had to make quite a few assumptions, but any way you look at it, this is a fantastic deal.
If Goldman buys back the preferred shares earlier than five years or takes longer than five years it’s a good deal…even if Goldman’s stock price goes nowhere. If it goes up, this is a great deal.
The only way to lose here is if Goldman goes bankrupt or interest rates soar to the levels of the early 80’s. But if the latter happened, Goldman shares would probably be a lot more valuable offsetting any losses incurred from the decline in value of the preferred shares.
Any way you look at it, this has the potential to be a truly huge success for Berkshire. Warren Buffett has proved why he’s the most successful investor of the past half century: he always keeps the odds in his favor. And, if you can, you should buy like Warren Buffett.
As a result, I don’t see this deal as Warren thinking Goldman shares are too cheap to pass up, but more like the deal is too cheap to pass up.
Disclosure: I have no position in any of the companies mentioned.
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This article has 17 comments:
1. As you say, Jan 2011 110 call option for GS shows the implied volatility is 44%, however, we can imagine the volatility of GS stock will drop soon, maybe a implied volatility of about 30% is more appropriate for valuing these warrants.
2. You value the future dividend with 10% discount rate, but maybe we need a much higher discount rate like 15% considering the current high-risk status of financial markets. What's the yield of GS corporate bond? The discount rate should be higher than the bond yield.
3. Instead of assuming GS will buy back the shares in five years, why not simply using the preferred shares valuation formula P = D/R, since D is always fixed at 10% ?
We’ve also got to account for the value of the $500 million a year in dividends. The Net Present Value of those (discounted at a 10% rate) are worth $1.96 billion if it Berkshire holds them for five years.
Preferred Share Value
Finally, we’ve got to take the value of the preferred shares. Goldman has to buy these back at some time or they will be an annual $500 million drain on its annual cash flow and pre-tax profits.
The value of these will fluctuate with general interest rate levels and Goldman’s creditworthiness so it’s tough to put a value on these. But if we take an 8% discount rate, the present value of a $5.5 billion repayment from Goldman in five years (as part of the deal, Goldman has to pay a 10% penalty for buying back the preferred shares) is $3.62 billion.<<<
Your analysis is not consistent. You use a 10% discount rate for the dividend but 8% on the preferred stock value. Why?
He says the taxpayer overpaying for crappy mortgages is a great idea for all us little people -- but not good enough for him. He gets a much better deal for himself.
Yes, this is a great deal for BRK, but that doesn't mean it wasn't a great deal for GS as well. GS needed to raise capital - does this deal result in a lower cost for that new capital?
Napkin math included.
Buffett's $5B preferred issue works exactly the same as if GS borrowed the money, in that it has a high pseudo-interest rate, is junior to all of Goldman's existing debt, is senior to the common shares, and will never appreciate from its current value of $5.5B. The only difference is that it adds to Goldman's capital position.
Because it will never appreciate in value, as traded preferreds may, BRK also gets warrants. BRK can buy that same $5B of stock at a price close to the market price when the deal was struck, at any time in the next 5 years. So BRK's benefit will include any common stock appreciation.
BRK gets a 10% premium for the pseudo-loan, plus 10% annually until it's retired, on top of the benefit from common stock appreciation. The deal is similar (except for balance sheet accounting) to a short-term loan at 10% in exchange for 43.48 million warrants at a price of about $104.50 (applying the 10% retirement premium to the warrants instead of the preferred). Sweet deal.
But the real question from the GS side is whether they are better off than they would have been raising capital in another way. GS decided to raise $7.5B. The cost was the 43.48 million BRK warrants plus 20.32 million shares sold at $123 (GS raised an additional $2.5B because the response to the offering was greater than expected - it's quite reasonable to say that GS may have underpriced the offering). Cost of raising $7.5B: 63.8 million shares, or 15% dilution of ownership, plus $42M per month until the company retires the BRK preferred. My guess is that GS will retire that preferred issue as soon as this financial crisis is over. Because they raised more than originally planned in the offering, they have $2.5B more capital than originally expected - half the cost of retiring the BRK shares. I'll put the over/under on retirement at 1 year, in part for simplicity's sake. If this is accurate, the BRK preferred dividend will add $500M to the cost of the capital raising. Discounting it at 6%, for the 63.8 million shares in effect GS raised $7.028B at $110.16 per share.
So what if GS had chosen to do a $7.5B equity issue instead? Would it have been able to price the issue at at $110.16? Based on the price of GS and MS in the day of and after the BRK investment, it's not clear to me that this is the case.
However, based on the uncertainty of the situation, it is clear to me that this was a good deal for GS. While it is possible that they could have raised the money in a public offering priced slightly higher than $110.16 (resulting in less dilution), it's also quite possible that such an offering would have failed. Removing this risk was certainly worth more than the potential reduction in dilution.
I'm long GS and MS.