The Warren Buffett Case Study

TREVECCA NAZARENE UNIVERSITY

MBA FINANCE ONLINE

STUDY QUESTIONS FOR THE WARREN BUFFETT CASE

1. What is the possible meaning of the changes in stock price for Berkshire Hathaway and Scottish Power plc on the day of the acquisition announcement? One might think that a good deal for one side of the transaction might mean a bad deal for the other side, but the stock prices of both companies went up. What might explain this? What does the $2.55 billion gain in Berkshire’s market value of equity imply about the intrinsic value of PacifiCorp?

Warren Buffett attended Columbia University where he studied under Professor Benjamin Graham.  Professor Graham developed a method of identifying undervalued stock.  Graham focused on the value of assets, networking capital and physical assets.  Buffett took that method further and focused on valuable franchises that were unrecognized by the market.  When Berkshire Hathaway and Scottish Power announced the acquisition Hathaway’s share prices jumped up 2.4% and Scottish Power’s share price jumped 6.28% on the day the acquisition was announced.  Berkshire’s stock increased because this acquisition would strengthen their subsidiary company MidAmerican Energy Holdings company.  The Scottish Power’s share price increased because Berkshire was able to see the intrinsic value of the company and found value with purchasing PacificCorp from Scottish Power.  This showed the market and investors that the intrinsic value of Scottish Power made it an undervalued company.  With the large purchase price of their subsidiary PacificCorp, the company’s stock price increased.  

1. Based on the multiples for comparable regulated utilities, what is the range of possible values for PacifiCorp? What concerns, if any, might you have about these values?

The range for PacificCorp comparing to the Enterprise values listed in Exhibit 10 are in the range from 4.277 billion up to 9.023 billion for the mean and between 4.308 to 9.289 billion for the median.  This is based on the performance of other regulated energy firms.  PacificCorp would fall somewhere within this range.  The one concerning value I see is that the revenue numbers are significantly lower that the EBIT and EBITDA and lower than the Net income numbers.  This would cause me to look into how the numbers for these three sections were being calculated.  This might be overstated or potentially skewed.

1. Assess the bid for PacifiCorp. How does it compare with the firm’s intrinsic value? Does the case provide enough information to determine the intrinsic value?  I don’t believe that enough data to fully assess the bid for PacifiCorp.  We can see the financials for the company and what was offered but we don’t get much information on PacifiCorp’s intrinsic value.
2. How well has Berkshire Hathaway performed? How well has it performed in the aggregate? What about its investment in MidAmerican Energy Holdings?

Berkshire Hathaway has performed very well over the last 20 years.  They started with a cotton manufacturing company which was experiencing market changes and Berkshire Hathaway saw this challenge and decided to invest in two insurance companies.  This allowed Berkshire Hathaway’s to branch out their investments into other areas providing them increased growth and revenue opportunities.  Berkshire’s year end closing share price was $102 in 1977 and on May 24, 2005 the share price reached $85,500.  This is a significant growth over the years.  Their insurance companies lead the growth on revenues and identifiable assets.  Their philosophy to reinvest their earnings into the companies allows them to continue to grow stable and consistent performing companies.  

1. What is your assessment of Berkshire’s investments in Buffett’s “Big Four”: American Express, Coca-Cola, Gillette, and Wells Fargo? (Note that the last column in Exhibit 3 of the case does not have a heading. You can assume that the heading should be “Annual Average Total Return”.)  

Berkshire’s invested $3.83 billion in the “Big Four” companies in multiple transactions between May 1988 and October 2003.  The Big Four companies consist of American Express, Coca-Cola, Gillette, and Wells Fargo.  In Exhibit 3 we see that in 2005 American Express had an annual average total return of 17% and a market value of $8.546 billion.  Berkshire Hathaway owned 12.1% of the company and the cost of investment was 1.470B.  Berkshire owned 8.3% of shares to the Coca Cola company.  Coca Cola’s market share was 8.328 Billion and had an average rate of return of 16%. Berkshire paid 1.299 billion investment. Berkshire owned 9.7% of Gillette company.  Gillette’s market share was 4.299 billion and the average rate of return was 14%. Berkshire invested 600 million in the company. The final company is Wells Fargo.  Berkshire owns 3.3% of the company.  Wells Fargo market value is 3.508 billion and has an average rate of return of 13%. Berkshire invested 369 million.

Since Berkshire has invested 3.84 billion in the four companies, the combined market share values for the four companies is $24,681 billion.  That is a significant growth in their investments and all four companies are holding a steady market share and average rate of return.  I would say Berkshire made a solid investment that is providing a good return on their investment.

1. Critically assess Warren Buffett’s criticism of capital market efficiency.

Warren Buffett’s philosophy was that accounting alone could not provide the full picture on the value of a company.  He looked at economic values as well as financial values.  He felt that capital market efficiency was not enough to provide a true picture.  Since he did not agree with market analysis and financial reporting alone, he felt that capital markets were not an accurate representation of a company.

1. Critically assess Buffett’s investment philosophy. Explain whether you agree or disagree with each point of his philosophy, and why you agree or disagree.

1. Look at economic reality, not accounting reality.

I think that looking at the economic reality is important because the accounting reports do not give a full picture of the company. However, looking at economic reality and not looking at the accounting reports for the historical information is not providing the investor the full picture.  The two together provide a historical and a forward looking perspective.  

1. Consider opportunity costs.

I absolutely agree that companies need to consider the opportunity costs of investments and work.  If the value of an investment does not provide a positive return at the end of it, what the investment worth is?  The example of a college education was an excellent way to explain opportunity costs.  Looking at the cost of a college education coupled with the lost wages of a college student’s time in college vs working, did that benefit the student?  You have to consider the earnings the student will receive now that he has a degree. How much more will the student earn going forward with the degree, and what would the students earns be without the degree. This gives a true quantifiable value to the opportunity costs..