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The Real Reason Buffett Bet Big on Goldman Sachs

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Sep 30, 2008
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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.

Earlier this 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, Financial).

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 an 8% 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, instead of what he buys.

As a result, I don’t see this deal as Warren thinking Goldman shares were too cheap to pass up, but more like the deal was too good to pass up. That’s probably the real reason he took out such a big bet.

Good investing,

Andrew Mickey

Chief Investment Strategist, Q1 Publishing

Disclosure: I have no position in any of the companies mentioned.

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