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Could You Really Make 200+% On JPMorgan With Reasonable Assumptions And Risk?

Could you really make 200+% on JPMorgan with reasonable assumptions and risk?

There have been a number of articles recently recommending JPM shares .We trade JPM at our fund and are in a bullish position but our overall fund position is flat or neutral. One particular article caught my attention suggesting that JPM shares could double by 2018.

The author used very reasonable inputs in his discounted cash flow analysis to arrive at a double or 100% on his JPM investment by 2018. Many investors are unaware that several financial derivatives still exist as a result of TARP. Many warrants issued as part of the TARP program that helped finance banks in 2008 still trade actively. Generally speaking these companies issued ten year warrants in conjunction with preferred stock to the treasury in return for cash to be used to shore up equity capital. Some companies have repurchased their preferred stock and warrants and some left the warrants outstanding. JP Morgan still has warrants outstanding.

It's definitely worth taking a look at these warrants as a long substitute if you believe JPM will double in a little less than 6 years. JPM common stock is currently trading at $49.50 and warrants expiring on October 18, 2018 and with a strike price of $ 42.42 are trading at $ 14.60. I warrant gives the right to buy 1 share at $42.42 expiring October 18, 2018.

A back of the envelope calculation easily shows the leverage advantage of the warrants in this scenario. If on October 18, 2018 JPM is trading at $ 99 per share the investor will have doubled his money in addition to receiving dividends along the way. A fantastic return indeed. However if the investor had instead chosen to instead invest in the TARP warrants, he would find the intrinsic value with the stock at $99 in 2018 would be $ 46.58. The calculation is ($99 Stock price - $42.42 strike price= $46.58 warrant price). So a $14.60 purchase for the warrant would have returned 219% over the same period.

The actual calculation for "fair value" of the warrants is somewhat complicated right now and depends very much on the inputs for volatility, type of cash flow (dividends vs. share buybacks) and the level of interest rates. My current fair value shows JPM warrants a little rich at $14.60. Using the current stock Price, an annualized volatility of 18%, interest rate of 3% and dividend yield of 2% And 2067 days to expiration produces a model value of $11.93. In my opinion, the two most questionable inputs are the volatility estimate which reflects today's low volatility environment and the interest rate where the real risk free rate is well below 2% for 6 years. A change of 100 basis points reduces or increases the option value by roughly a dollar so a 2% input with no other changes would value this warrant slightly under $11.

The major point remains the same, even with these warrants trading at a slightly elevated value there is tremendous leverage for a scenario painted by this analyst that strikes me as quite reasonable. A possible return of well over 200% is in the cards.

Disclosure: I am long JPM.

Additional disclosure: We are actually long the warrants as part of an overall balanced neutral strategy. This is not a specific recommendation for JPM its an idea to consider given the scenario referred to in my post.This is my personal opinion and not the opinion of coastal management group LLC.