Warren Buffett: Black-Scholes Formula Is Total Nonsense

Summary

In this insightful discussion, Warren Buffett and Charlie Munger delve into the complexities of options and their inherent value, critiquing the Black-Scholes model for its limitations, especially in long-term options. They emphasize the importance of aligning employee compensation with shareholder interests, highlighting Berkshire Hathaway's unique approach to incentives and performance. The conversation also touches on the flaws in corporate compensation systems, advocating for a more rational and performance-based approach.

Takeaways

• 📊 Understanding the value of options is crucial, even if one doesn't need to understand the Black-Scholes model in detail.
• 🏠 The concept of options is illustrated with the example of a house purchase, where an option to buy at a certain price has inherent value.
• 📉 The cost of issuing options is often unpopular, but it's important to recognize that any option has value and can impact a company's financials.
• 💼 Some businesspeople may receive options for little or no cost, which can be a contentious issue in corporate finance.
• 📈 The Black-Scholes model is an attempt to measure the market value of options, but it relies on past volatility and may not always be accurate.
• 📊 Berkshire Hathaway's stock had a low beta, indicating low volatility, but this didn't necessarily mean lower option value for those who understood the business.
• 💡 Charlie Munger suggests that the Black-Scholes model can give 'silly' results for long-term options, highlighting its limitations.
• 💰 Warren Buffett and Charlie Munger capitalized on the mispricing by the Black-Scholes model to make significant profits.
• 🤝 The speakers advocate for a compensation system that aligns employee interests with shareholder interests, rather than a random or capricious system.
• 🏆 They criticize the current stock option system for being a lottery ticket that doesn't necessarily reward performance or contribution to the company.
• 💼 The Berkshire approach to compensation is to tie rewards to actual performance and control, avoiding the pitfalls of a one-size-fits-all system.

Q & A

What is the general concept of options as discussed in the transcript?

Options are financial instruments that provide the holder with the right, but not the obligation, to buy or sell an underlying asset at a specific price within a certain time frame. The transcript emphasizes that all options have value, regardless of the underlying asset, and understanding this value is crucial in business.

Why is the cost of issuing options considered unpopular in some circles?

The cost of issuing options is unpopular because it represents a potential expense or loss of value for the company. When options are granted, especially when they are given for 'very little or for nothing,' it can be seen as a dilution of shareholder value.

What is the Black-Scholes model and its purpose?

The Black-Scholes model is a mathematical formula used for pricing European-style options. Its purpose is to determine the theoretical value of an option based on various factors including the asset's price, strike price, time to expiration, and volatility.

How does Berkshire Hathaway's approach to stock options differ from the norm?

Berkshire Hathaway, as described in the transcript, does not use the traditional stock option system due to its perceived randomness and potential misalignment with actual performance. Instead, they prefer to tie compensation to what is under the reasonable control of the individual being measured.

What is the issue with using past volatility as a measure for option pricing?

Past volatility is not always a reliable indicator of future price movements. The transcript mentions that Berkshire's stock had a low beta (a measure of volatility), but this did not necessarily reflect the true option value to someone who understood the business.

How did Berkshire Hathaway capitalize on the use of the Black-Scholes model by others?

Berkshire Hathaway made a large commitment based on a differing view from the Black-Scholes model's pricing. This resulted in a profit of 120 million dollars, highlighting the potential for profit when others rely on mechanistic formulas that may occasionally misprice options.

What is Warren Buffett's view on the use of mechanistic formulas in pricing?

Warren Buffett appreciates when others use mechanistic formulas because they may be right most of the time, but he looks for the one time when they are wrong. This allows Berkshire Hathaway to capitalize on mispricings in the market.

How does Berkshire Hathaway approach employee compensation?

Berkshire Hathaway's approach to employee compensation is to pay for performance but ensure that the performance metrics are tied to what is actually under the control of the individual. They avoid using stock options as a form of compensation due to the reasons mentioned in the transcript.

What is the criticism of the current corporate compensation systems in America?

The criticism is that many corporate compensation systems are capricious and do not accurately reflect the contributions made by individuals. There is a significant disparity in compensation rates between top executives and lower-level employees, and often a disconnect between executive compensation and the actual performance of the company.

Why is the current compensation system described as a 'lottery ticket'?

The 'lottery ticket' analogy is used to describe the random and often undeserved nature of stock options as a form of compensation. It implies that some individuals may receive large payouts without necessarily contributing to the company's performance.

What is the role of compensation consultants in corporate America, and how is it viewed in the transcript?

Compensation consultants are often hired to determine executive pay. However, the transcript criticizes them for rarely recommending pay cuts or suggesting the removal of underperforming executives, thus contributing to inflated compensation packages.