2002: How would Buffett value a stock option?

AUDIENCE MEMBER: Hello, my name is Joseph Lepre (PH). I’m a shareholder from Minneapolis, Minnesota, and I’d like to thank you for this opportunity to ask a question.

Mr. Buffett, you mentioned earlier today that you’d be willing to sell insurance in exchange for stock options. If possible, could you please describe a methodology for the valuation of stock options, particularly in cases where there is no market pricing data available for the option being valued?

WARREN BUFFETT: Yeah, I would — I could figure out what I would pay for an option on a private business. I could figure out what I could pay for an option on a public business. It might be a little easier. I could figure out what I’d pay for an option on an apartment house or a farm.

I had a friend, I mean, when I was 20 years old, we developed a big plan and we were going to go out and option out — option farms, you know, outside of what were then the city limits of Omaha.

And we figured that if we offered a farmer a modest amount, which would be annual income to him, to option his farm at double the price it was bringing then, that it would, you know, he would be happy to sell for double the price that year, and maybe we could do something. And it might have worked out OK.

Every option has value. You know, I’ve got a house worth X. If you offer me a few dollars to give you an option at 2X for 10 years, I’m not going to take it, because there are all kinds of possibilities in terms of inflation.

All options have value. And people that get options usually understand that better than people that give options. I’m not talking about stock options now, but in other arenas.

So we would be happy, you know. I mean, what I could get — let’s say — we’ll just pull one out of the air. Let’s take an untraded company like Mars, Inc.

Would I be happy to have an option, a 10-year option on a piece of Mars, Inc. at some given price?

Sure, I would. And there’s an amount I would take for that — I would take in lieu of getting cash if I was writing a big insurance policy with Mars, Inc. They’re not going to do this with me, but that —

And I would be happy, you know, instead of if you buy homeowner’s insurance from me, if you want to give me an option on your house for 10 years, I’ll take that in lieu of the premium.

I’ll make my own calculation as to value. It won’t be Black-Scholes, although that might be the best arrangement under many circumstances, but I would probably crank into — in my own case.

We’ve bought and sold options some. And as a matter of fact, on June 3rd, Berkshire Hathaway will receive $60 million if the S&P 500 closes at 1150-something or below.

And two years ago, when the S&P was 14-something, we agreed for — on that June 3rd option, or whatever it was — $400 million nominal value, where, in effect the counter party would get the profit above 2,000 and something, 42 percent up from the current cash price. And we got the profit between 5 and 20 percent on the downside on a put.

People who were calculating the values of options at that time, under traditional methods, felt that that was a cashless transaction — that the value of the call that we gave was equal to the value of the put that we received. You know, I decided differently.

So, we don’t accept, blindly, option values as determined by the calculations of people who win Nobel Prizes. Instead, you know, we actually put an aspect of judgment into some.

There would be businesses that would come out with identical Black-Scholes values on options for 10 years, and we would pay a different amount for one than the other, maybe a significantly different amount.

But we would pay something for just about any option. And you know, it is the nature of prices in this world to change, and economic conditions to change. And an option is a chance to participate in a change without giving up anything other than that original premium you pay.

Many people just don’t seem to grasp that, but believe me, the people who are getting options on stock do grasp that.

And the people who are giving them, which are the shareholders, you know, represented by a group like this, who don’t have any real voice in giving it, but they sometimes don’t fully realize what’s being given away.

Imagine, you know, going up a few miles away from here and having two farms for sale. And you say to the guy, “How much do you want for them?” and they both say a thousand dollars an acre, but the one guy says, “But every year, I want you to option, you know, I want you to give me 2 percent of the place back at a thousand. So, you know, at the end of 10 years, 20 percent of the upside belongs to me, but you’ve got all the downside.” I mean, which farm are you going to buy? The one without the options or the one with the options? It’s not very complicated.

And we will — we are dead serious when we say we will take options in lieu of cash. Incidentally, the company that gives us those options in lieu of cash for an insurance premium has to record the expense in terms of the fair value of the option they’ve given us.

The only item for which they don’t have to record that as expense is compensation. But if they give it to us for their light bill, or if they give it to us for their insurance premium, or they give it to us for their rent, they have to call it a cost.

But only when it comes to the CEO’s compensation, and other people like it, do they not have to record it as a cost, and that’s because they’ve been able to get Congress to bow to their will and to their campaign contributions.

Charlie?

CHARLIE MUNGER: Yeah, the Black-Scholes crowd really did get a Nobel Prize for inventing this formula to value options, not executive stock options, but just options generally.

And if you don’t know anything about the company, except the past price history of stock transactions —

WARREN BUFFETT: And dividends.

CHARLIE MUNGER: — and if it’s — and the dividend being paid — and if the option is over a very short term, it’s a very good way of approximating the value of the option.

But if it’s a long-term option and you think you know something, it’s an insane way to value the option.

And Wall Street is full of people with IQs of 150 that are using Black-Scholes to value options that shouldn’t be tortured into the model.

And all of corporate — of America is using Black-Scholes to price stock options in the footnotes of the accounting statements, and they do that because it comes up with the lowest cost number.

WARREN BUFFETT: Well, they not only do that, but they assume the term is less than the actual term of the option. And I mean, they’ll do everything they can, and I’ve been in on these discussions. They’ll do everything they can to make the number look as low as possible. It’s that simple.

CHARLIE MUNGER: And they’re using a phony process to determine the number in the first place. So, it’s a Mad Hatter’s tea party, and the only thing that’s consisting — consistent — in it is that the whole thing is disgusting. (Laughter and applause)