Case Study of Finance

(a) What is the intrinsic value? A: The intrinsic value is a way to estimate the real value of a company or a capital, according to the present value of its future cash flow. Why is the intrinsic value so important? A: Intrinsic value is all important and is the only logical way to evaluate the relative attractiveness of investments and businesses. It shows investors the growth ability and profitability of the company or capital, which focus on its future trends. How to estimate the intrinsic value?

A: the intrinsic value is not a precise figure, which is estimated under various situations. Thus, under the fixed interest rates and forecast of future cash flows, the intrinsic value of a company or a capital can be estimated that the future value created during its remaining life divides the discount rate for those years. What are the alternatives to intrinsic value?

A: the intrinsic value aims to estimate the real value of a business. Therefore, the alternatives can be the book value, market value, fair value, etc. Why does Buffett reject them? A: As we all know, Buffett does not try to “time the market” —his is a strategy of patient, long-term investing. He is used to invest a product in long run. Meanwhile, the intrinsic value focuses on the future profitability, and then discounts it to the current cash value. That meets Buffett’s investment philosophy.

(b) Identify points where you agree and disagree with Buffett. A: Agree, The philosophy— Investing behavior should be driven by information, analysis, and self-discipline, not be emotion or “hunch”. Investment is a rational activity and the decisions should be made after analyzing all of the gained information. The impulse in investing behavior may make profit once or twice, but it will lose in the long term.

That is the reason why the benefit of retail investors is easily to be damaged in stock market. However, there is a same situation to the professional investor. As Benjamin Graham believed that an investor’s worst enemy was not the stock market, but oneself. Over the long term, stock prices should have a strong relationship with the economic progress of the business. Disagree,

The philosophy— Risk and discount rates.  It said that Buffett argued that he avoided risk, and therefore should use a “risk-free” discount rate. His firm used almost no debt financing. He focused on companies with predictable and stable earnings. In my mind, the risk cannot be avoided, and what can be done is just reducing it. As Buffett thought, his firms hardly had debt financing, then there was no risk affected the earning of companies. However, as we all know, there may have bad debts in business and trade, which can impact earnings as well.

Meanwhile, the risk may be incurred by the external of companies. For instance, the 2008 Financial Crisis and the recently event that American sovereign ratings was dropped from AAA to AA+ might both have influence on Buffett’s firms earning, more or less. As to me, I prefer the conventional thinking that the more risk one owns, the higher discount rates one will be. Just like the car insurance, the more accident a car suffers, the more car insurance it should be paid. Nevertheless, on the side of Buffett, it may be the perfect thinking.

Because it matches with Buffett’s theory to estimate the intrinsic value and it is said that Buffett often decides an investment within 30 minutes. In such short time and large workload, the simple is the best.

(b) Should Berkshire Hathaway’s shareholders endorse the acquisition of PacifiCorp? A: I do not think shareholders should endorse it. Firstly, Buffett have stated and implied that the firm’s goal of annual growth rate was 15%, even after acquiring PacifiCorp, but there was no data shown to support it. Meanwhile, there was another acquisition case can be used to compare this. Duke Energy acquired Cinergy for $9 billion.

From EXHIBIT 9, it shows that the profitability of PacifiCorp is much less than that of Cinergy Corporation. Last but not the least, comparing the figures EXHIBIT 6 and 7, in PacifiCorp the annual growth rate in shareholder between year 2004 and 2005 was about 1.72%, which was far lower than that of MidAmerican Energy Holdings Corporation shown in EXHIBIT 6.

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