Question about Investing in Warrants vs Equity

[Guest MikeTheCannon]

Geoff Gannon (gannononinvesting.com) had a post in October about Hostess Brands. In the post he challenges readers to figure out what would be a better way to invest in Hostess: via equity or via warrants? So far he hasn't posted any follow up and I haven't been able to come to an answer that I hold with high conviction. As such I was hoping people here might be able to help me out.

 

The way I see it, the warrants are effectively options and thus should be valued in the same way. In order to exercise a warrant you actually need two of them. That is, two warrants are good for one stock. The strike price is $11.50 and the company can effectively force you to exercise them if the stock price breaks $24.00. As such two warrants are basically equal to buying a call with a strike price of $11.50 while also selling a call with a strike price of $24. Using the CBOE's options calculator (and Friday's closing price) I came to the following values for options expiring November 4th 2021 (1448 days from Friday):

 

Call with strike at $11.50 = $4.2841

Call with strike at $24.00 = $1.3284

 

If you bought the $11.50 call while also selling the $24 call you would be out $2.9957. As such, one warrant should be worth half of this price: $1.47785. They closed on Friday at a price of $1.65. Since the warrants are currently trading at a premium I think the answer to Gannon's question is currently "buy the stock". The answer is (I think) a fluid one as the price of the stock and options can diverge from one another. For example, in the most recent 10K, the company lists the highs and lows for the company stock and warrant prices. The stock's lowest price during fiscal 2016 was $9.50 while the lowest warrant price was $0.16, which is a mind blowing divergence. If the stock price was $9.50 today those warrants would be worth $0.83715 (and this price isn't adjust for differences in "time value"), which makes the $0.16 warrants the better option.

 

Is this what Gannon is getting at? Or have I gone down a completely different road?

 

 

Here's a link to the post: http://www.gannononinvesting.com/blog/2017/10/13/hostess-brands-twnk-warrants

 

And CBOE's options calculator: http://www.cboe.com/framed/IVolframed.aspx?content=http%3a%2f%2fcboe.ivolatility.com%2fcalc%2findex.j%3fcontract%3dEB49AB28-BEC2-4D54-8BC0-156F1E41FCE1&sectionName=SEC_TRADING_TOOLS&title=CBOE%20-%20IVolatility%20Services

 

[racemize]

Personally, I would value it as I do in this essay:

https://drive.google.com/file/d/0BxTPR9eP5nWea0kwWnM4ZnJ0amM/view?usp=sharing

 

and decide what future growth is likely to occur and make a decision based on that.

 

Your approach makes sense given the ceiling on the warrant (which is shitty), but the growth of the equity is the real question to answer.  It's easy to pick warrant vs stock when you have that assumption set.

[rb]

One difference between a warrant and an call option is that the warrant will dilute the stock. So yo have to take the level of dilution into account when pricing the warrant.

[Guest MikeTheCannon]

Personally, I would value it as I do in this essay:

https://drive.google.com/file/d/0BxTPR9eP5nWea0kwWnM4ZnJ0amM/view?usp=sharing

 

and decide what future growth is likely to occur and make a decision based on that.

 

Your approach makes sense given the ceiling on the warrant (which is shitty), but the growth of the equity is the real question to answer.  It's easy to pick warrant vs stock when you have that assumption set.

 

Thanks Joel! I had downloaded all of your essays after the ROCE/Book Value thread. I'll move this specific one up to the top of the list.

[Guest MikeTheCannon]

One difference between a warrant and an call option is that the warrant will dilute the stock. So yo have to take the level of dilution into account when pricing the warrant.

 

Thanks for this! It's definitely an important aspect that I overlooked.