Warren E Buffet

7/22/2019 Warren E Buffet

1/13

Capital Market

Warren E Buffet

Case Report Assignment

Syndicate YP47B:

Adilla Nurlina

Ayu Eka Putri

Dwi Kurnia Putri

Indri Yul Avianti

Siti Larissa Sarasvati

Yara Putri Genevera

Yulianita Rahayu

Master of Business Administration

School of Business and Management

Institut Teknologi Bandung

2013


2/13

Case Overview

This case took place in 2005 and speaks about Warren Buffets acquisition of

PacifiCorp (subsidiary of Scottish Power) for $5.1 billion in cash and $4.3 in

liabilities and preferred stock. Back then; Buffet was the CEO of Berkshire

Hathaway, which is a corporation that dives into various industries and business

activities. Their business is ranging from grocery distribution to flight services.

Apparently, it appeared that they wanted to broaden their portfolio by acquiring

PacifiCorp, an electric utility company that provided a low cost energy to 1.6 million

in six states on the west coast. In accordance with the announcement of the

acquisition, Berkshires stock price has been increased by 2.4% (equivalent to $2.55

billion) and on the other hand, Scottish Powers also increased by 6.28% and S&P

500 closed up 0.02%. Furthermore, Warren Buffet also invests in several large

companies, such as American Express, Coca-Cola, Wells Fargo together with Gillette

and referred those companies as Berkshire Hathaways Big Four.

In addition to the details concerning Berkshires business activities, this case

also highlighted Warrens investment philosophies, which summarized into eight

points that are the concept of economic reality, the cost of lost opportunity, value

creation (time value of money), measuring performance in intrinsic value, risk and

discount rates, diversification, investing behavior, and the arrangement of agents and

owners.

In the end, there are numerous problems and questions brought by this case,

such as whether the PacifiCorp acquisition will serve the long-term goals of Berkshire

Hathaway or whetherthe bid price is also appropriate, and what is the explanation for

Berkshire increasing share price at the announcement. Furthermore, as Scottish Power

privately held PacifiCorp, how did Berkshires offer measure up against the

companys valuation implied the multiples for comparable firms.

Objectives

In accordance to this case, we attempt to study Mr. Warren Buffett, the "Oracle of

Omaha that has reached the summit of business excellence and has become the most

judicious financial investor through:


3/13

1. Analyzing his investment activities, such as the acquisition of PacifiCorp andBig Four,

2. Exploring his eight investment philosophies.

Analysis

I. Acquisition of PacifiCorp

On May 24, 2005, Warren Buffett announced that MidAmerican Energy Holdings

Company (Berkshire Hathaways subsidiary) would acquire and electric utility

company, PacifiCorp whose parent Scottish Power. Berkshire has utilized $5.1 billion

in cash, which will be paid in the next 12 to 18 months, together with $4.3 liabilities

and preferred stock to complete the acquisition.There are several questions arise

regarding the acquisition, which are:

a. What might account for the share price increase for Berkshire Hathawayat the announcement?

When a firm acquires another entity, there usually is a short-term effect on the stock

price of both companies. As described in the Exhibit 1, we can see that either

Berkshires and Scottish Powers stock price has been increased due to the acquisition

announcement. This happened to be a positive respond from the market (market

approve for the acquisi tion) . Furthermore, we consideredthat the major motivation to

this respond is apparently psychological; where public tend to trustBuffetts

movements as he already known with his excellent record on investment.

Evidence on Buffets remarkable ability can simply be found in the case. First

of all, this case mentioned that Berkshire has 24% compound stock prices annual

growth, while large firms averaged growth is 10.5% per year over the same period,

which is1965 to 1995.This comparison shows that Berkshires performances have

been outstanding.

The second one is regarding Berkshires equity investing activities, where

Buffet acquired many large companies; some of those acquisitions called Berkshire

Hathaways Big Four; namely American Express, Wells Fargo and Gillette together


4/13

with Coca-Cola. According to Exhibit 3, we may see that Buffets criteria seem to be

consistency of companys operation history, quality of the companys capacity in

order to create value, and attractiveness of long term prospects. Most of the company

has a very outstanding performance as it shown in the exhibit.

The third one is the Berkshires investment in MidAmerican. We perform a

simple analysis of Berkshire ROI. The calculation obtained from the data that

provided in Exhibit 6.

Table 1.1 IRR Analysis of MidAmerican

Table 1.1 show us the calculation of IRR, where it can be obtain by computing

Berkshires share of MidAmericans free cash flow. In order to derive the terminal

value, we have to calculate terminal free cash flow using CAPM and growth rate at

3%, which

CAPM

Beta 0.57

Risk-free rate 5.76

Market Risk Premium 10.5%

Cost of Equi ty 9.32%

Figure 1. CAPM

The final result shows us that Berkshire return on its investment in

MidAmerican is 71%, which happened to be a very large return. Furthermore,in


5/13

February 2005, Warren Buffet also announced as one of the richest people in the

world by Forbes. 1

b. Was the bid price is appropriate?

In order to respond to this question, we will look at two things, which are

companys intrinsic value and Companys valuation implied by the multiples for

comparable firms.

Intrinsic value of PacifiCorpIntrinsic value is the present value of the future expected performance of a firm.

Warren Buffet considers this is one of the most important tools in investment. Here is

our calculation on intrinsic value:

Step 1 : Calculating CAPM (see Figure 1)

Step 2 : Calculating the present value of the initial investment of

Berkshire Hathaway

a.

Companys valuation implied by the multiples for comparable firms

Because PacifiCorp was privately held by Scottish Power, which means that

PacifiCorp does not pay dividend. Companys valuation implied by the multiples for

comparable firms is more reasonable method than using market value. Exhibit 9 and

exhibit 10 present implied valuations for PacifiCorp using averages and medians of

those firms multiples.

Figure 2. Enterprise Value multiples based on the performance of comparable firms

1Forbes. (2005). World's Richest People. Available:

http://www.forbes.com/static/bill2005/LIRC0R3.html. Last accessed 29 Aug 2013

Alliant $ 5,600

Cinergy $ 13,231

NSTAR $ 5,287

SCANA $ 7,967

Wisconsin $ 7,691

PacifiCorp $ 6,252

$ 9,289

Median $ 7,691

Mean $ 7,955

(in million dollars)

Enterprise Value


6/13

Figure 3. Market Value multiples based on the performance of comparable firms

Figure 2 shows enterprise value multiples of comparable firms, the bid price

derives from the table should be around $6,252 to $9,289 but Berkshires offers $9.4

billion to acquire PacifiCorp. Using this method apparently the bid price is not

appropriate, Berkshires offers measure is overvalue even though the enterprise value

of PacifiCorp is above the enterprise values mean and median of comparable firms.

Based on exhibit 9 and exhibit 10 Cinergy Corp is the most valuable firm of

comparable firms and the most similar firm as Duke Energy had acquired PacifiCorp,

in a $9 billion stock swap.

The market value multiples of comparable firms showed by figure 3,

PacifiCorp market value of equity is around $ 4,277 to $5,904. If Berkshire offers

$5.1 billion cash to acquire PacifiCorp Equity and the deal will take 12 to 18 months

the present value ofBerkshires offer will be $4,665 million. Berkshire might be gain

equity value from the acquisition about $1,239 million.

Discounted Cash FlowAnother private firm valuation method is Discounted Cash Flow. Discounted

Cash Flow indicates the net present value from our investment discount at some

required return of the firm. The required return of the firm can be found by calculate

the Weighted Average Cost of Capital (WACC). In order to find the WACC value of

PacifiCorp, there are some components of the firm cost of capital that need to be

calculated first, which are cost of debt, cost of equity, or cost of preferred. This

WACC value indicates amount of return that the firm has to pay as the result caused

by financing the company.

Alliant $ 3,333

Cinergy $ 7,989

NSTAR $ 2,898SCANA $ 4,486

Wisconsin $ 4,048

PacifiCorp $ 4,277

$ 5,904

Median $ 4,048

Mean $ 4,551

MV Equity(in million dollars)


7/13

1) Cost of Capital Estimates Calculation Cost of Debt PacifiCorp.Interest Rates of PacifiCorp is 7% which can be found using Income

Statement of PacifiCorp on Exhibit 7. Cost of debt is interest rates multiply by

earning after tax rates.

Cost of Debt = before-tax-cost of debt * (1-T)

The tax Rate is 40%, so PacifiCorp cost of debt is 4%.

Tax Rate 40%

Rd 7%COD 4%

Cost of EquityCost of equity can be found using the CAPM formula. The components of the

CAPM formula are Risk free rate which is according to the Gitman text book usually

the short-term treasury bills, market required return of equity, and risk premium is

different amount of risk market return and risk free rate.

Cost of Equity = Rf + (*(Risk Premium)

Cost of Equity = 6% + (0.77 x (11%-6%))

= 9%

Assumption Refference:

D+E 9400 pg 1

D 4300 pg 2

E 5100 pg 3

D/(D+E) 46%

E/(D+E) 54%

Interest Rates 7% Exhibit 7

Cost of Debt 4%

Rf 6% Footnote

Rm 11% Footnote

Beta PacifiCorp 0.77 Exhibit 9

Cost of Equity 9%

WACC 8%

Expected Growth:

Sales 12%

Expenses 10%

Shareholder Wealth 24% pg 13

Intrinstic Firm Value 15% pg 13

Tax 40%


8/13

The risk premium is market required return of equity distract by risk free rate.

PacifiCorp cost of Equity is 9%.

Weighted average cost of capital (WACC)In this case Berkshires offer $9.4 billion to acquire PacifiCorp. This payment

consists of $5.1 billion in cash and $4.3 in debt and preferred stock. Target level of

debt-to-asset ratio in acquiring the plant is 46% to calculate cost of capital. Therefore

the equity-to-asset ratio is 54%.

WACC = D/V*After-tax cost of debt + E/V*Cost of equity

WACC for PacifiCorp cash flow is 8%. This cost of capital will be used to

calculate Net Present Value of the investment.

2) Calculating NPVThe result of the NPV on the basis of the current cash flow provided in

appendixes in this paper and information provided in case material. This calculation

used data in Exhibit 7 as comparison and projected cash flow from 2006 to 2013

based on assumptions as stated before. The Net Present Value of PacifiCorp

Acquisition is $9257 million.

The Discounted Cash Flow method showed that a bid for PacifiCorp of $9.400

million will create $9257 million net present value and on the announcement day

Berkshire gained $2.55 million in market value. The bid price is appropriate because

Berkshires offer according to discounted cash flow method will generate positive

intrinsic values for the company. This method is radically different from current,

implied, and expected values for comparable firms.

According to their acquisition criteria released in the 2004 annual report

PacifiCorp meets at least 5 of the 6 principles needed. They are considered a large

purchase with pretaxearnings at $656 million and have positive earnings growth over

the last two years (only two years of data available). PacifiCorp already has

management in place with steady growth meaning it would be simple for Berkshire

Hathaway to take over without large amounts of restructuring. In addition to the

beneficial, qualitative factors of PacifiCorp, the companys fundamentals prove the

company will be a successful investment. Referring to Exhibit 10 in the case, looking

at its relative enterprise valuation based on operating measures (e.g., revenues,

operating profit, and net income), it yields an average enterprise value of $8.015

billion, which is higher than its primary competitors. Also, when comparing


9/13

PacifiCorps average relative valuation of expected market value it yields $5.042

billion, better than the firms primary competitors average of $4.551 billion by 11

basis points.

II. Buffetts Investment PhilosophyBuffetts persona in the world of investments has been uncomparable. His investment

principles have stood the time and often used by many investors. Buffets principles

are actually simple, easy to be understood and followed. Basically, this gurus

character is conventional as he saw prospects of an investment in the long-term

perspective and his success is a combination of careful calculation, courage and

patience. In the following, we will provide our assessment towards the philosophies.

1) Economic Reality; not accounting realityWe believe this first philosophy is by far the most important and may differ

Buffet with any other investor. He stated that financial statements prepared by

accountants conformed to rules that might not adequately represent the economic

reality of a business, as accounting reality was conservative, backward looking, and

governed by GAAP. Warren Buffett also defined economic reality at the level of

business itself, not the market, the economy, or the security. In conclusion, what we

have studied from this philosophy is we should take into account many aspects in

considering an investment, just like Buffet that uses 12 investing tenets or key

considerations, which are categorized in the areas of business, management, financial

measures and value.2

2) The cost of lost opportunityIn his investment decision-making process, Buffet always compares his choice

with another best opportunity. Actually, comparing one choice against another seems

ordinary, but what we found interesting here is that Buffet considering the cost of

loosing the other opportunity. In this case, we took that Buffer saw the true cost of an

investment is what you give up (opportunity) to get it. This includes not only the

money spent in buying that asset but also the economic benefits that one has to do

2Investopedia. (2011). What Is Warren Buffett's Investing Style?. Available:

http://www.investopedia.com/articles/05/012705.asp. Last accessed 29 August

2013.


10/13

without because one bought that particular asset and thus can no longer buy

something else with that money.

3) Value Creation: Time is moneyWarren Buffett defined intrinsic value as the discounted value of the cash that

can be obtained from a business during its remaining life. Buffet calculates the value

of a business as the net cash flows expected over the life of the business, discounted at

an appropriate interest rate. Net cash flows are companys owner earnings over a long

period. Something like the thirty-year U.S. Treasury bond rate can beused as a

measure of the interest rate for this calculation.Thediscounted cash-flow approach is

veryconservative as long as an appropriate discount rate isapplied. In spite of its

uncertainty, intrinsic value is important because we cant deny that book value is

actually meaningless in relation with future potential growth. Therefore, the lesson

that we can obtain from this third philosophy is we should really pay attention to the

business future potential growth, not the amount of investment that we put.

4) Measure performance by gain in intrinsic value, not accounting profitWarren Buffetts long-term economic goal is to maximize Berkshires average

annual rate of gain in intrinsic values with per-share basis. He does not measure the

economic significance or performance of Berkshire by its size, but by per-share

progress and he will be disappointed if the rate of per-share progress does not exceed

that of the average large American corporation. According to this philosophy, we

believed that gain in intrinsic value being referred to is similar to EVA (Economic

Value Added) or Market Value Added measures. These measurement focuses on the

ability to earns returns in excess of the cost of capital. The difference between a

company's return and its cost of raising capital is called "EVA" (Economic Value

Added). Unlike traditional accounting measures, (EPS and ROI), EVA focuses on

economic profit to capture the true performance of a company. In other words when

we measure performance by gain in intrinsic value we are estimating the amount by

which earnings exceed or fall short of the rate of return shareholders and lenders

could get by investing in other securities of comparable risk. Furthermore, we believe

even though intrinsic value is a key pillar, accounting profit is also necessary to be

assessed as it also reflects the quality of a company.


11/13

5) Risk & Discount Rates ConventionalWarren Buffett defined risk as the possibility of loss or injury. His company

used almost no debt financing. To avoid risk, he also put a heavy weight of

investments on certainty by focusing on companies with predictable and stable

earnings. Thus, the idea of a risk factor does not make sense to him so that he utilized

a risk-free discount rate such as the rate of return on the long-term (for example, 30-

year) U.S. Treasury bond. We believe, here one would disagree with Buffett. In the

world of finance, risk and return is one of the basic principles, where its related to

one another as we often heard, the greater risk the greater the return. There are also

many risks, which cannot be completely avoided and predicted, such as natural

disasters, wars and political events. Even though Warren Buffet known as the Oracle

of Omaha, he happened to be a normal person with great ability, not a fortuneteller.

Therefore it is not prudent to discount all future cash flows at the risk free rate and we

cannot ignore existence of risk and should not use risk free rate to get intrinsic value,

which the return of investment will be overvalued.

6) DiversificationWarren Buffett suggested that investors typically purchased far too many

stocks rather than waiting for one exceptional company. Investors should pay

attention to only businesses that they understand. This principle sometimes

misunderstood, that Buffet is somehow anti diversification. Actually, from our point

of view the means of this philosophy is an investor should understand a companys

operating fundamentals, where they need to adopt the concept of intelligent investing.

Investor should act like the owner of the business, not the owner of a piece of paper.

In this case, very few business owners are comfortable and have the ability to operate

a number of companies at the same time, therefore, Buffet believed that it is not

necessary to diversify if the objectives is only for spreading away investment risks. In

conclusion, we have learned that diversification will be much better if its

accompanied with deep understanding on the business itself.

7) Investing behavior should be driven by information, analysis & self-discipline;not by emotion or hunch

Instead of following Mr. Markets opinion, it would be wiser for investors to

form their own ideas of the value of their holdings, based on full reports from the


12/13

company about its operation and financial status. Warren Buffett did not believe in the

stock market. When he invested in stocks, he invested in businesses. He behaved

according to what is rational rather than according to what is fashionable. He didnt

try to time the market (trade stocks based on expectations of changes in the market

cycle). Instead, he employed a strategy of patient, long-term investing. In conclusion,

we can learn that it is essential to use intellectnot emotionwhen investing.

8) Alignment of agents & ownersWarren Buffett claimed, He is a better businessman because he is an investor.

And he is a better investor because he is a businessman. More than 50 percent of the

family net worth of four of Berkshires six directors contained shares in Berkshire

Hathaway. Moreover, the senior managers of Berkshire Hathaway subsidiaries held

shares in the company, or were compensated under incentive plans that related to the

potential returns from an equity interest in their business unit.

The lessons that we can take from this philosophy is that:

Spend wisely Overcome your fear of risk Focus on the long term Invest in quality business Sell losing stocks when the market is up, buy winning stocks during a

crash

Make decisions to invest based on how well money is being used bycompany management

Conclusion

Bakshire should acquired PacifiCorp for a bid price of $9,400, even though

PacifiCorp valuation using Multiples valuation of comparable firms showed that a bid

price of PacifiCorp for $9,400 million according to this method is not appropriate and

Bekshire would not get any intrinsic value. The second method, which is discounted-

cash-flow method calculate the future benefit of the investment (intrinsic value). The

NPV of investment is $9,257, so bid price according to discounted cash flow method

is appropriate and Bekshire will generate intrinsic value which is almost twice


13/13

Bekshires offer. Even more record of Warren E Buffet in investment world have

been outstanding, some of them is The Successful of The Big Four. In the

announcement day, the share price both of Bakshire and Scottish Energy is increasing.

Which indicates a positive respond from the market (market approve for the

acquisition). So Bakshires should acquire PacifiCorp, and bid price of $9,400 is

appropriate.

The successful of Warren E. Buffett is a combination of a good calculation,

the courage, and patience in investing in the right time. Patience is important to buy

stocks. The right time to buy stocks according to Warren Buffett is when stock prices

decline massively. Period collapse in the stock market is often responded by market

participants with a sense of fear and panic. In fact, the crisis in the stock market can

give us a gold opportunity to gain profit on stock investments. When the collapse

occurs in the stock market, then you will receive shares of good companies at super

discounted prices. Buffet character in investing is by look at the prospect of an

investment in the long-term perspective. Discounted price by Warren Buffet is not

only in nominal terms, but also discounted valuations.

Warren E Buffet

Documents

Transcript of Warren E Buffet