According to the case, there are stock price changes for Berkshire Hathaway and Scottish Power plc on the day of the acquisition announcement. Also, the bid price for PacifiCorp is $9. 4 billion. After knowing this announcement, Berkshire Hathaway’s Class A shares price went up and make them gained in market value $2. 17 billion. In Berkshire and other investors’ point of view, After Berkshire takeover PacifiCorp, it might have a good development and future so that the stock price went up. Berkshire believed that PacifiCorp can have good earning returns in the future.
The intrinsic value is more valuable than its cost so they are willing to pay $9. 4 billion to acquire. Moreover, based on the multiples for comparable regulated utilities, we can see that in exhibit 10, the range of possible enterprise values for PacifiCorp is form $6. 252 billion to $9. 289 billion. And the range of possible market value of equity is $4. 277 billion to $5. 904 billion. In this case, Berkshire used $9. 4 billion to acquire the electric utility PacifiCorp. This price is out of the range neither of possible enterprise value nor of possible market value.
So, a very obvious question is raised here----why Berkshire was willing to purchase PacifiCorp at such high price? In the article, Buffett mentioned “intrinsic value is all important and is the only logical way to evaluate the relative attractiveness of investment and business. ” That means Buffett make purchases at the price below or equals the intrinsic value. And we all know market value is the price at which an asset would trade in a competitive auction setting. At the point of possible market value, this bid price is much higher than the market given.
The question here is how Buffett can know the intrinsic value of PacifiCorp is worth that much when the market possible highest price is just $5. 904 billion. On the other hand, enterprise value is a measure of a company's value, often used as an alternative to straightforward market capitalization. Since the bid price is over the possible highest price of enterprise value, does it mean PacifiCorp still hiding some undiscovered value form the market? So, whether the bid price and the intrinsic value of PacifiCorp are the same?
We know that from the case the bid for PacifiCorp is a little bit expensive since it is over the range of possible value. For compare with the intrinsic value, we might use the U. S 30 year treasury rate (U. S 30 year treasury rate=4. 6%) and let Net income be the following cash flow to perform a simple discounted cash flow analysis, we find that PV =7553(1+4. 6%)+7553(1+4. 6%)2+….. +7553(1+4. 6%)? is greater than the bid price. After Buffett acquired Berkshire Hathaway in 1965, Berkshire Hathaway grew from $102 to $85,500, which has an annual increase of 24% since 1965.
And it has decline due to technology change and inflation, it becomes better after closing textile side of their business. Also, Scottish Power has outperformed the S&P 500 Index from March to May2005, but Berkshire Hathaway is below S&P 500 Index. That’s attracted Berkshire to purchase PacifiCorp. Thus, it should be a good investment for Buffet ince they raise their voting interest from 9. 7% to 9. 9% and 76% to 83. 7% of economic interest in equity of MidAmerican in 2002. They can have major stake in company without violating utility laws.
But they should have more profit investment because the net earning has decrease from 416million in 2003 to 170million in 2004. Berkshire’s investment in the “Big Four” which include: American Express, Coca-Cola, Gillette, and Wells Fargo. Berkshire invested $3. 83 billion through multiple transactions for 12. 5 years on a weighted basis. Looking at the numbers of the "Big Four", each company created more value than the market. The value of the investment was $24. 681 billion, which gain for $20. 849 billions. So it should be very successful investments.
From Warren Buffett’s perspective, intrinsic value is the discounted value of future expected performance. Using the flows of cash which can be taken out of a business during its remaining life and together with 30 years US treasury rate to calculate the discounted value. It is importance because it can be measure the ability to earn returns in excess of the cost of capital, rather than the accounting profit, which can know the attractiveness of a business. Furthermore, the gain in intrinsic value could be modeled as the value added by a business above and beyond the charge for the use of capital in that business.
On the other hand, the alternatives to intrinsic value are accounting profit, performance, firm size, etc. But, Buffett reject accounting profit as a measurement mainly because the accounting reality was conservative, backward looking, governed by GAAP, ignore the market value of a business and the performance of a business, also ignore the intangible assets for a business such as patents, trademarks, expertise, reputation, etc. He believed that investment decision should be based on economy reality, which included many items that accounting profit had ignored.
Now, it is time to judge the eight principles that Buffett’s investment philosophy says. At first, Mr. Warren E. Buffett said that their operating and capital-allocation process would not be affected by accounting numbers such as financial statement and any consolidated numbers. The book also says the accounting reality is restricted by the generally accepted accounting principles, GAAP, so that some intangible assets would not be valued fairly and that makes the economic reality sound more properly useful. Economic reality in the book told us that it is calculated from cash flows and should be only judged by the business itself.
As a student in Finance, I will not completely consent to the approach in the book since future cash flows should be calculated and predicted from the past per-year earnings in some way. By the same token, the accounting values such as income statements and balance sheets are important factors to look at the progress of a firm such as the return on equity and price-per-earning ratio. On the other hand, the economic reality is also important in terms of the intrinsic value, the quality of management and the firm’s capacity to create value and some intangible assets would be valued fairly.
Thus, both approaches are quite valuable. At second, Mr. Warren E. Buffett compared an investment opportunity against the lost opportunity such as other returns available in the market and the comparison becomes the benchmark of performance. As a result, I would agree with this idea since we then can use this benchmark to extend to other companies all over the world. The third point that Mr. Warren E. Buffett told us is to compare between the intrinsic value and the book value by inserting the time value of money so that we can know whether the project would be value creation or destruction.
In my opinion, using both values would be a good approach to evaluate a project since we have to know how a company performed in past and how it will go in the future but there are two things that we have to focus on are the prospective rate of return and the required rate of return. The forth conclusion made by Mr. Warren E. Buffett is to measure performance by gain in intrinsic value on a per-share basis, not accounting profit. In my viewpoint, this would not be true since both individual and the whole performance should be taken into account.
The fifth sentence would be how much value we should use for the risk and discount rate. Buffett asserted that his investment is with certainty. Therefore, he used the rate of 30-year US Treasury bond as a discount rate. By all means, this would be wrong according to the academic study that says all investments have difference degrees of risks but if he can be definitely sure that his investment is analogous to be risk-free, it might be possible that this rate is till appropriate. The sixth point that Mr.
Buffett disagreed with is diversification. To be honest, I would like to divide investors into two groups, one is big and the other is small. For a small investor, diversification would undoubtedly cost so much that it is better to concentrate on one or two stocks. Nevertheless, it would be more terrific for a big investor to diversify not only because of reducing the firm-specific risk, but also the market risk by investing stocks with correlation not equal to one. Hence, this statement still remains some questions.
Nevertheless, if we look the investments of Berkshire Hathaway, it does diversify its business in insurance, apparel, building products, finance and even flight services. Thus, what Mr. Buffett said still remains a contradiction. The seventh statement that Mr. Buffett narrated is to declare that investment should be decided on information, not on hunch. This sounds to be correct and rationality comes out better. On the other hand, Mr. Warren E. Buffett scorned the academic theory of efficient market hypothesis. That kind of phenomenon would be possible but not often.