“First, you can’t buy the kind of stock Buffett got on any market, anywhere in the world. Berkshire Hathaway is buying $5 billion of perpetual preferred stock with a 10% coupon. These shares are senior to both Goldman’s other preferred stock and its common stock. That means no other shareholders will receive any dividends until Buffett has been paid his 10%, in full, each year.

“And that’s not all… To sweeten the deal for Buffett, Goldman agreed to include a warrant (a long-term call option) that entitles Berkshire Hathaway to buy an additional $5 billion in regular common stock, at $115 per share. (Goldman’s trading for about $130 now.) Thus, if Goldman can turn things around, Berkshire will receive an enormous payday down the road. It will be entitled to buy stock at $115, no matter what the price has risen to five years from now.

“Most investors have no idea what this means. When they read about a warrant being granted, they just shrug. They can’t do the math to figure out how much Goldman has given to Berkshire. It’s like reading Greek to most people. So let us tell you what no newspaper will…

“The value of an option to buy stock in the future at a fixed price is based almost entirely on the duration of the option. The further out you go in time, the more valuable they become. Right now, the only similar options you can buy on Goldman are $120 calls that expire in January 2011 – about two and a half years from now. These options would cost you $42 to buy today.

“Using these options as a rough guide, our options trading expert, Jeff Clark, estimates the options Buffett received from Goldman are worth about $78 each. On a $5 billion position, that’s a total value of $3.2 billion.

“In other words, Buffett received a security worth about $3.2 billion in exchange for his $5 billion investment in a high-yielding preferred stock. His net exposure is only $1.8 billion. On this capital at risk, he’s getting paid $500 million per year. That’s a 27.7% annual return. And he may eventually end up owning 10% of the company.”

Source: Warren Buffett is Buying Four Percent of Goldman Sachs