We believe our base case assumptions are fairly conservative in that we do not project increasing ROE or the common stock trading in excess of 1 times book value. It seems likely that if banking profits improve (higher ROE), stock prices could trade at 1.5 to 2 times book value, which would result in an exceptional return on the warrants. For example, if book value per share is $125 and PNC Common trades at 1.5 times book value at the end of 2018, each warrant would have an intrinsic value of about $120, or nearly an 11 times multiple on the original $11 investment (41% IRR over 5+ years).
The potential returns on TARP Warrants appear very compelling, but we also bear in mind that they could ultimately prove worthless should the banks record significant impairments, the ROEs fall further or the price-to-book multiples decline. However, we view the prospects of a "zero" to be quite remote given (i) the starting point of depressed ROEs and low price-to-book multiples and (ii) our focus on Wells Fargo and PNC, both of which are well-capitalized and well-managed banks with strong franchises that should allow them to continue compounding book value per share over the life of the warrants. Nevertheless, we have decided to limit the Fund's investment in TARP Warrants to 2% of the Fund at cost. While small today, they have the potential to grow into much larger positions over the next few years. We are always happy when a 2% position appreciates to become a top-ten holding in the Fund.
From Third Avenue Management's semi-annual 2013 letter.