Traditional corporate equity warrants

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12. Analysis - break-even and capital fulcrum point

We saw in an earlier section that the warrant premium can be used to assess the 'expensiveness' of a warrant, and can also be used to compare one warrant with another. The premium on a warrant will be greatly influenced by the time to expiry of the warrant. All other things being equal, a warrant with a maturity of 4 years, will have a greater premium than a warrant with a maturity of only 2 years. But, although maturity is a very important factor affecting warrant premium, the calculation itself takes no account of it.

Assume there are two warrants on the same company's shares: Warrant A with a premium of, say, 25% may appear 'cheaper' than Warrant B with a 33% premium. But if Warrant A has a 3-year maturity, and Warrant B a 4-year maturity, the latter might be thought better value. How can we tell?

Break-even

Referring to a previous example (see diagram), the premium of 25% on this warrant represents the fact that it is 25% more costly to acquire a share by buying a warrant and exercising it, than simply buying a share directly in the share market. However, the premium of 25% can be regarded in another way: the share price must rise 25% for the warrant holder to break-even on his investment. In other words, if the share price rises 25% to 150, the warrant holder can exercise the warrant at 100, sell the received share at 150, and make 50. And the profit of 50, exactly recompenses the warrant holder for what they originally paid for the warrant. Technically: the warrant's intrinsic value has increased to equal the original warrant price.

Warrant premiums

If the warrant has a maturity of 3 years, we can express this 25% (the required increase) as an annualised appreciation rate, and call this the Break-even rate. The mathematical formula is -

Break-even rate formula

For our example,

Breakeven = 7.7%

Hence, 7.7% is the annual growth required in the share price from this point to warrant expiry, for the warrant holder to break even on his warrant investment.

Returning to the question posed a few paragraphs earlier ("How can we tell which is better value, Warrant A or Warrant B?), the table below analyses this with a few figures.

To re-cap: Warrant A has a premium of 25% and a maturity of 3 years; while Warrant B has a premium of 33% and a maturity of 4 years. Which is better value? This is not easy to answer looking just at the premium, as that takes no account of the life warrant. However, looking now at the new Break-even calculation, we can see that while Warrant A has a Break-even rate of 7.7%, Warrant B has a rate of 7.5% - making it (albeit marginally) better value. In the case of Warrant B, the share price only has to increase at annual rate of 7.5% to pay-off today's warrant price of 60.

So, the break-even rate is a great advance on the simple premium indicator, allowing us to more efficiently compare two warrants. But it's not a very ambitious measure - merely calculating the share growth rate that will return our original warrant investment to us. But we're hoping to make money here! For this, we turn to the next calculation refinement: the Capital Fulcrum Point.

Capital fulcrum point

Referring back to the example Warrant A and the break-even calculation, if the share price grows annually at 7.7%, at expiry the warrant-holder will have a zero return on his investment. If he had originally invested £10,000 in the warrants, at warrant expiry he would have £10,000 (minus a few transaction costs). If, on the other hand, he had invested the £10,000 directly in the shares, he would have £12,500 at warrant expiry - a 25% gain. Why bother with the warrants?

However, if the share price had grown at an average rate of over 7.7%, then the gearing on the warrants would begin to kick and the warrants start to quickly out-perform the underlying shares. The Capital Fulcrum Point (CFP) measures the point at which the warrant performance catches up with that of the share, and is poised to overtake it. CFP, like Break-even, is measured in terms of the share price annual growth, and defined as -

Capital fulcrum point formula

Plugging in our values for our warrant example we get -

CFP=12.62%

If our calculation is correct, this means that if the share price increases at an annual rate of 12.62% over the 3-year life of the warrant, an investment in the shares or the warrants will return the same amount. This is confirmed in the table below.

If the shares increase at an annual rate of 12.62% (the CFP), at the end of the 3 years, they will have risen to a value of 171.4 (a total increase of 42.8%). At maturity the warrant will therefore be worth 71.4 (intrinsic value = 171.4-100), which is also a total increase of 42.8% - the same as the shares.

Let's quickly look at the case where the share price now rises at an annual rate of, say, 15%-

Here, while the share price has risen 52.1%, the warrant has beaten this with an increase of 65%.

We've now analysed three hypothetical cases for the shares and warrant:

1. Annual share growth = 7.7% (Break-even rate): share price out-performs the warrant.
2. Annual share growth = 12.62% (CFP): share price performs in line with the warrant.
3. Annual share growth = 15% (above CFP): share price under-performs the warrant.

The conclusion from the above is that if an investor believes a share will grow at an annual rate below the CFP they should invest in the shares. But if they believe the share price will grow above the rate of the CFP, they will get a better return investing in the warrants, not the shares.

Notes on the Capital Fulcrum Point

• The CFP is the most important - and most advanced - warrant technical indicator we will cover in this course. It is useful because it combines a warrant's time value, parity ratio and maturity in the one indicator.
• Investors - usually quite rightly - are wary about warrants with high premiums, and avoid them. However, there is some evidence to suggest that warrants with a very long life (say, over 8 years), which naturally tend to have high premiums, are under-valued. The CFP can be used to identify those long-life warrants, that, despite having high premiums, are relatively under-valued.
• The best use of the CFP is as a comparative measure. Despite warrants having varying characteristics, the CFP calculation normalises many of these (i.e. premium and maturity) to allow warrants to be directly compared against each other.
• The CFP also allows for direct comparison of the warrant with the underlying shares. In some cases, the CFP figure may be inconclusive. For example, if the CFP is equal to 7%, it could be difficult to estimate whether the share price will grow above or below that rate. However, if the CFP is 23%, just knowing that the average annual appreciation of the equity market is around 9% indicates that a target of growth of 23% for any equity will be very challenging. Conversely, a CFP of 3% would seem a very undemanding target, and an investment in the warrant obviously preferable to that in the shares.

1. Introduction 2. What is a warrant? 3. The warrant market 4. Advantages of warrants over shares - the magic of gearing 5. Further attractions of warrants 6. Disadvantages of warrants 7. Fundamentals - warrant terms 8. Fundamentals - intrinsic value and parity ratio 9. Basic analysis 10. Analysis - time value and premium 11. Analysis - gearing 12. Analysis - break-even and capital fulcrum point 13. Analysis -sample spreadsheets 14. Analysis - summary 15. Investing strategies 16. Dealing in warrants 17. Warrant exercise 18. Further topics 19. Further information 20. Conclusion

• Andrew McHattie on Covered Warrants