CASE 1
WARREN E. BUFFETT, 2005
Synopsis and Objectives
Set in May 2005, this case invites the student to assess Berkshire Hathaway’s bid, throuh MidA!erican Enery Ho"dins Co!#any, its who""y owned subsidiary, $or the reu"ated enery%uti"ity &aci$iCor#' (he task $or the student is to #er$or! a si!#"e va"uation o$ &aci$iCor# and to consider the reasonab"eness o$ Berkshire’s o$$er' Student ana"ysis readi"y e)tends into the invest!ent #hi"oso#hy and the re!arkab"e record o$ Berkshire’s chair and CE*, +arren E' Bu$$ett' (he case is an introduction to a $inance course or a !odu"e on ca#ita" !arkets' (he ana"ytica" tasks are straiht$orward and intended to #rovide a s#rinboard into discussion o$ the !ain tenets o$ !odern $inance' (hus, the case wou"d be use$u" $or setting themes at the beinnin o$ a $inance course, inc"udin risk%and%return, econo!ic rea"ity -not accountin rea"ity., the ti!e va"ue o$ !oney, and the bene$its o$ a"in!ent o$ aents and owners •
o$ investors in the ca#ita" !arket linking valuation to the behavior o$ modeling good practice in !anae!ent and invest!ent usin +arren Bu$$ett as an e)a!#"e by returnin to the i!ae o$ Bu$$ett re#eated"y durin a $inance course to ask students what Bu$$ett wou"d "ike"y do in a situation
•
characterizing stock prices as e/ua"in the #resent va"ue o$ $uture e/uity cash $"ows
•
exercising simple equity-valuation skills
Questions
1' +hat is the the #ossib"e #ossib"e !eanin !eanin o$ the chanes chanes in stock stock #rice $or $or Berkshir Berkshiree Hathaway and Scottish &ower #"c on the day o$ the ac/uisition announce!ent S#eci$ica""y, what does the 2'55 bi""ion ain in Berkshire’s !arket va"ue o$ e/uity i!#"y about the intrinsic va"ue o$ &aci$iCor# 2' Based Based on the !u"ti# !u"ti#"es "es $or co!#ar co!#arab" ab"ee reu"at reu"ated ed uti"itie uti"ities, s, what is the rane o$ #ossib"e #ossib"e va"ues $or &aci$iCor# +hat /uestions !iht you have about this rane ' Assess Assess the bid $or &aci$iCor &aci$iCor#' #' How does it co!#are co!#are with the the $ir!’s $ir!’s intrinsi intrinsicc va"ue
3
Case 1 +arren E' Bu$$et, 2005
3' How we"" has Berkshire Hathaway #er$or!ed How we"" has it #er$or!ed in the areate +hat about its invest!ent in MidA!erican Enery Ho"dins 5' +hat is your assess!ent o$ Berkshire’s invest!ents in Bu$$ett’s Bi 4our A!erican E)#ress, Coca%Co"a, i""ette, and +e""s 4aro 6' 4ro! +arren Bu$$ett’s #ers#ective, what is the intrinsic va"ue +hy is it accorded such i!#ortance How is it esti!ated +hat are the a"ternatives to intrinsic va"ue +hy does Bu$$ett re7ect the! 8' Critica""y assess Bu$$ett’s invest!ent #hi"oso#hy' Be #re#ared to identi$y #oints where you aree and disaree with hi!' 9' Shou"d Berkshire Hathaway’s shareho"ders endorse the ac/uisition o$ &aci$iCor#
1' What does the stock market seem to be saying about the acquisition of PacifiCorp by Berkshire Hathaay! (his o#enin o$$ers the o##ortunity to deve"o# the notion that stock #rices are the #resent va"ue o$ e)#ected cash $"ows' Moreover, it dea"s with the i!!ediate o#enin #rob"e! o$ the case the !arket’s res#onse to the &aci$iCor# announce!ent' 4ina""y, it shou"d he"# to !otivate a discussion o$ Bu$$ett’s invest!ent #hi"oso#hy' 2' Based on your on analysis" hat do you think PacifiCorp as orth on its on before its acquisition by Berkshire! (his /uestion e)#ands u#on the o#enin /uestion and he"#s dee#en the !ystery about the ac/uisition:the bid #rice see!s to be a $air"y $u""%#rice o$$er $or &aci$iCor#' ' Well" maybe Buffett is overpaying#does he have a record of overpaying in the past! Here, the discussion shou"d shi$t to an ana"ysis o$ Berkshire’s enera" record, its e)#erience with MidA!erican, and its e)#eriences buyin e/uity #ositions in the Bi 4our' (he enera" conc"usion wi"" be that Bu$$ett has done very we"" as an investor and as the !anaer o$ Berkshire' 3' Here are the ma$or elements of Buffett%s philosophy& What do those elements mean! 'o you agree ith them! *n a sideboard, one cou"d "ist the !a7or to#ic headins iven in the case' (he ai! here shou"d be to discuss the intuition behind each #oint why Bu$$ett ho"ds those views and what they i!#"y $or his work' ;$ the students a"ready have been e)#osed to the !a7or under#innins o$ !odern $inance, this se!ent o$ the discussion wou"d take the $or! o$ a /uick review' 4or novices, this se!ent wou"d warrant s"ower deve"o#!ent' 5' (et%s return to the basic issue& )s the PacifiCorp acquisition a good or bad deal! Why! (his /uestion returns the discussion to the o#enin and ai!s to rationa"i
5
Case 1 +arren E' Bu$$et, 2005
#rice and the #ositive !arket reaction to the announce!ent' As a va"ue investor, Bu$$ett wou"d #robab"y say that he sees so!ethin that others do not:the #ositive !arket reaction is 7ust the !arket revisin its e)#ectations about the $uture #ro$itabi"ity o$ &aci$iCor#' 6' *ake a vote on hether the shareholders should endorse the acquisition& +or those of you ho believe that PacifiCorp ill be a good purchase" hat $ustifies your belief! +or those of you ho voted no" hy did you oppose it! Hearin $ro! both sides wi"" serve as a su!!ary o$ the !a7or the!es in the case and wi"" invite a discussion about the sustainabi"ity o$ Bu$$ett’s record'
See the $ir!’s +eb site, htt#==www'berkshirehathaway'co!, $or u#dated re#orts as we"" as a co!#i"ation o$ Bu$$ett’s "etters to shareho"ders'
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Case 1 +arren E' Bu$$et, 2005
Case Analysis Investor reaction to the PacifiCorp announcement @iscussio n /uestion 1
(he investor reaction suests that the dea" wi"" not on"y create va"ue $or &aci$iCor#’s ac/uirer, Berkshire Hathaway, but a"so $or the se""er, Scottish &ower' ;n $act, as a re"ative !atter, it wou"d a##ear that the !arket sees !ore va"ue accruin to Scottish &ower because o$ its divestiture o$ &aci$iCor# than to Berkshire, as a resu"t o$ its ac/uisition o$ the co!#any' Students cou"d be encouraed to consider why this !iht be so -i'e', why Scottish &ower wou"d see! to ain !ore bene$it $ro! the dea" than Berkshire Hathaway.' (he 2'55 bi""ion increase in Berkshire Hathaway’s !arket va"ue indicates an e)#ected bene$it to Berkshire $ro! the ac/uisition' So!e students wi"" !easure the e)tent o$ this bene$it as a ain o$ 2'55 bi""ion in Berkshire’s !arket va"ue o$ e/uity divided by &aci$iCor#’s 12'19 !i""ion shares outstandin or 6'>5 #er &aci$iCor# share more than Bu$$ett is #ayin' Berkshire is o$$erin 5'1 bi""ion in cash $or &aci$iCor#’s e/uity, $or a #er%share #rice o$ 16'3? a"toether, this wou"d i!#"y a #er%share e)#ected va"ue $or &aci$iCor#’s shares o$ 2'2>' ;s this a $air esti!ate o$ &aci$iCor#’s intrinsic va"ue Students !ust #er$or! their own va"uation o$ &aci$iCor# in order to arrive at an inde#endent 7ud!ent about this va"ue' Valuation of PacifiCorp
Because &aci$iCor# is a #rivate"y he"d co!#any that does not #ay a @iscussion dividend, the case does not contain enouh in$or!ation to derive a va"uation $or /uestions 2 and &aci$iCor# usin !arket va"ues or the dividend discount !ode"' ;t is necessary, there$ore, to re"y on an i!#"ied va"uation $or the $ir! usin !u"ti#"es $ro! co!#arab"e reu"ated uti"ities' Case E)hibit > #rovides $inancia" data $or the co!#arab"e $ir!s, and case E)hibit 10 #resents i!#"ied va"uations $or &aci$iCor# usin averaes and !edians o$ those $ir!s’ !u"ti#"es' Table 1 #resents a su!!ary o$ the rane o$ va"uations #rovided in the case (ab"e 1' Su!!ary o$ &aci$iCor# va"uation esti!ates' nterprise Value as !ultiple of
!V "uity as !ultiple of#
8
$ev%
6,252 6,593
&IT
9,885 >,29>
&IT'A
>,02 >,086
(et Income
8,5>6 8,55
Case 1 +arren E' Bu$$et, 2005
PS
&oo) Value
3,288 3,09
5,>03 5,689
Because the case states that it wou"d take 12 to 19 !onths $or the dea" to ac/uire &aci$iCor# to c"ose, the instructor !ay wish to so"icit a #resent va"ue $or Berkshire Hathaway’s o$$er $or the e/uity #ortion o$ &aci$iCor#' An a##ro#riate discount rate !ay be derived usin the ca#ita" asset #ricin !ode" -CA&M.' 4ootnote 1 in the case e)#"ains that the yie"d on the 0% year 'S' (reasury bond was 5'86 and that Berkshire’s beta was 0'85, and the case states that the "on%run !arket return was 10'5' So Berkshire’s cost o$ e/uity !ay be esti!ated as >'2' sin this rate to discount Berkshire’s 5'1 bi""ion o$$er over 12 or 19 !onths, we et a #resent va"ue o$ about 3'8 bi""ion' Berkshire’s o$$er $or &aci$iCor# was, there$ore, rouh"y in "ine with the rane o$ #eer $ir! va"uations' (his does not e)#"ain why the !arket reacted so #ositive"y to the news o$ the ac/uisition' ;t is #ossib"e that the investors #erceived #otentia" syneries between &aci$iCor# and MidA!erican, but in the hih"y reu"ated and reiona""y $ocused e"ectric%uti"ity business, such syneristic bene$its !ay be weak' +as there #erha#s so!ethin in Bu$$ett’s record as an investor that "ed to the !arket’s res#onse &uffett*s record @iscussio n /uestions
(he case a$$ords three o##ortunities to ana"y
65 to 1>>5' ;n co!#arison, wea"th creation $or "are $ir!s averaed 10'5 #er year over the sa!e #eriod' (he $irst chart in the case he"#s students visua"i
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Case 1 +arren E' Bu$$et, 2005
Berkshire’s return on invest!ent can be a##ro)i!ated by co!#utin Berkshire’s share o$ MidA!erican’s $ree cash $"ows, the cash $"ows avai"ab"e to a"" debt and e/uity c"ai!s' (he inco!e state!ent and ba"ance sheet data in case E)hibit 6 !ay he"# us derive Berkshire’s share o$ MidA!erican’s $ree cash $"ows $ro! 2001 to 2003, revea"in that Berkshire had an interna" rate o$ return -;DD. on this invest!ent o$ 81' +hibit T(, #resents those ca"cu"ations' Berkshire%s experience ith equity investments (he data in case E)hibit ive a $oundation $or a si!#"e assess!ent o$ the !a7or e/uity invest!ents by Berkshire' +ith a c"ass o$ novices, the instructor cou"d !otivate the! to observe that a"" those issues have !arket va"ues considerab"y hiher than their costs' +ith a c"ass o$ students !ore e)#erienced in $inance, it wou"d be #ossib"e to esti!ate a ho"din%#eriod return $or Berkshire’s invest!ents in the Bi 4our' sin the in$or!ation in this e)hibit and its $ootnote, we $ind that Berkshire’s invest!ents in A!erican E)#ress, Coca%Co"a, i""ette, and +e""s 4aro enerated a co!#ound annua" rowth rate o$ 16'08' Students cou"d be encouraed to co!#are this return with the "on%ter! return $or a"" "are stocks, 10'5'
&uffett*s Investment Philosophy @iscussion /uestions 6 and 8
Bu$$ett’s invest!ent #hi"oso#hy reads !ost"y "ike a su!!ary o$ the theory o$ !odern $inance' As the subheadins in the case indicate, the e"e!ents o$ the #hi"oso#hy are as $o""ows 1' Econo!ic rea"ity, not accountin rea"ity 2' Account $or the cost o$ the "ost o##ortunity ' 4ocus on the ti!e va"ue o$ !oney 3' 4ocus on wea"th creation 5' ;nvest on the basis o$ in$or!ation and ana"ysis 6' (he a"in!ent o$ aents and owners is bene$icia" to $ir! va"ue Bu$$ett stron"y disarees, however, with three other e"e!ents o$ !odern $inance 1' .se of risk-ad$usted discount rates (he !ethod he uses see!s rather si!i"ar to the certainty e/uiva"ent a##roach to va"uation -i'e', discount certain cash $"ows at a risk%$ree rate.' A"thouh it see!s doubt$u" that the cash $"ows he discounts are tru"y certain, the very $act that he !atches risk"ess cash $"ows with a risk%$ree discount rate i!#"ies an a##roach consistent with the risk%and%return "oic o$ the CA&M'
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Case 1 +arren E' Bu$$et, 2005
2' Benefits of portfolio diversification A"thouh Bu$$ett disavows #ort$o"io diversi$ication, the breadth o$ Berkshire Hathaway’s ho"dins #robab"y a##roaches e$$icient diversi$ication' Case E)hibit 2 ives a breakdown o$ Berkshire’s diverse business se!ents -a"so described in the case.? case E)hibit ives a "istin o$ Berkshire’s 10 !a7or investees' 4ro! the "ist, students cou"d be asked whether the #ort$o"io "ooks diversi$ied:this shou"d sti!u"ate a discussion o$ what diversi$ication !eans to the! and what it !iht !ean in $inance theory' (he case does not #rovide the data with which to co!#"ete an ana"ysis based on !arket va"ues and asset a""ocations, but by 7ust "ookin, one !iht identi$y #ossib"e industry concentrations in Berkshire’s ho"dins' (hose concentrations do not see! to account $or the bu"k o$ Berkshire’s !arket va"ue' (he $ir!’s #ort$o"io consists o$ an assort!ent o$ odd !anu$acturin and service businesses suested in the case, #"us so!e !a7or e/uity ho"dins -case E)hibit . that are not easi"y c"assi$ied in the concentration rou#s' (he !ass o$ research on #ort$o"io diversi$ication suests that it does not re/uire very !any di$$erent e/uities to achieve the risk%reduction bene$its o$ diversi$ication' @es#ite his #ub"ic disaree!ent with the conce#t o$ diversi$ication, Bu$$ett see!s to #ractice it' ' Capital-market efficiency Bu$$ett’s e!#hasis on the va"ue o$ in$or!ation asy!!etries see!s to con$ir! so!e a##reciation $or e$$iciency in security #rices' 4ro! his #ub"ic state!ents as re#orted in the case, Bu$$ett’s disaree!ent with e$$iciency $ocuses on two as#ects •
(he conce#t o$ #assive #ort$o"io !anae!ent -i'e', inde)in.
•
(he i!#"ication that /uoted #rices e/ua" intrinsic va"ues
(he theory o$ e$$iciency does not abso"ute"y #rec"ude bene$its o$ active !anae!ent or the #ossibi"ity that #rices !ay not e/ua" intrinsic va"ues' But it does suest that without an in$or!ation advantae or so!e unusua" ski"", it wou"d be very di$$icu"t to earn su#ernor!a" returns consistent"y over ti!e' ;t is in this conte)t that +arren Bu$$ett a##ears to be a !a7or ano!a"y' (he su#ernor!a" returns o$ Berkshire Hathaway suest that it is #ossib"e to beat the !arket by a wide !arin' Sti"", Bu$$ett’s invest!ent sty"e is consistent with e$$iciency in so!e i!#ortant ways •
•
'iscipline and rationality ;$ one is tryin to beat the !arket, it !akes no sense to invest in shares that are $air"y #riced' Bu$$ett’s /uotations in the case and his ac/uisition #hi"oso#hy in case E)hibit 9 suest that he is "ookin $or the !arket’s #ricin ano!a"ies' ookin $or the ano!a"ies -the rationa"ity #art. and wa itin to $ind the! -the disci#"ine #art. are not inconsistent with a !arket that enera""y #rices securities e$$icient"y' ;ndeed, one cou"d arue that the activities o$ investors such as Bu$$ett he"# to create the e$$iciency that he denies' )nformation By virtue o$ Berkshire’s "are stockho"dins in se"ected $ir!s, Bu$$ett ho"ds directorshi#s and en7oys an in$or!ationa" advantae unavai"ab"e to outside investors' ;n$or!ation advantaes are va"uab"e in a wor"d o$ on"y se!i%stron e$$icient !arkets'
10
Case 1 +arren E' Bu$$et, 2005
Conclusion
(he $ina" issue raised by the case has to do with the sustainabi"ity o$ Bu$$ett’s record' A bid $or &aci$iCor# o$ >'3 bi""ion does not see! unreasonab"e re"ative to current co!#arab"e va"uations' 4or the &aci$iCor# ac/uisition to be a success in the sense o$ !atchin historica" returns at Berkshire, Bu$$ett’s e)#ectations $or &aci$iCor# !ust be radica""y di$$erent $ro! current, i!#"ied, and e)#ected va"ues $or #eer $ir!s' +ith an invest!ent o$ this si
11
Case 1 +arren E' Bu$$et, 2005
As described here, the case ives the novice a broad introduction to the va"uation o$, and invest!ent in, e/uities' (he e"e!ents o$ this introduction inc"ude the $o""owin •
•
e) #ost ana"ysis o$ invest!ent returns -Berkshire, MidA!erican, and the Bi 4our. and co!#arison o$ those returns with a bench!ark, such as the S& 500 ;nde) or the ;bbotson tota" return $iures
#eer !u"ti#"es va"uation ana"ysis o$ &aci$iCor# •
•
discussion o$ the !eanin o$ share%#rice !ove!ents $o""owin the announce!ent o$ the &aci$iCor# ac/uisition review o$ the !a7or tenets o$ $inance in the conte)t o$ Bu$$ett’s invest!ent #hi"oso#hy
12
Case 1 +arren E' Bu$$et, 2005
E)hibit (1 -A$$( % &.//TT0 ,2
Bib"iora#hy $or +arren E' Bu$$ett
Bu$$ett, Mary, and @avid C"ark' *he /e Buffettology0 *he Proven *echniques for )nvesting 1uccessfully in Changing ,arkets *hat Have ,ade Warren Buffett the World%s ,ost +amous )nvestor ' -ew Iork Si!on Schuster., 2002' Cunninha!, awrence A' Ho to *hink (ike Ben$amin 2raham and )nvest (ike Warren Buffett ' -ew Iork Mcraw%Hi""., 2002' :::' *he 3ssays of Warren Buffett0 (essons for Corporate merica ' 1st rev' ed' -ew Iork Cunninha! rou#., 2001' Hastro!, Dobert ' *he Warren Buffett Way' 2nd ed' -ew Iork John +i"ey Sons., 2003' He""er, Dobert' Business ,asterminds0 Warren Buffett ' -@or"in Kinders"ey &ub"ishin., 2000' Ki"#atrick, Andrew' 4f Permanent 5alue0 *he 1tory of Warren Buffett ' -ew Iork Andy Ki"#atrick &ub"ishin E!#ire., 2003' :::' Warren Buffett0 *he 2ood 2uy of Wall 1treet ' re#rint ed' -ew Iork &"u!e., 1>>5' owe, Janet' Warren Buffett 1peaks0 Wit and Wisdom from the World%s 2reatest )nvestor ' 2nd ed' -ew Iork John +i"ey Sons., 1>>8' owenstein, Doer' Buffett0 *he ,aking of an merican Capitalist ' -Main Street Books., 1>>6' Morio, Ayano' Warren Buffett0 n )llustrated Biography of the World%s ,ost 1uccessful )nvestor ' -ew Iork John +i"ey Sons., 2003' *’ouh"in, Ja!es' *he 6eal Warren Buffett0 ,anaging Capital" (eading People' -ondon icho"as Brea"ey &ub"ishin., 200' Deyno"ds, Si!on' *houghts of Chairman Buffett0 *hirty 7ears of .nconventional Wisdom from the 1age of 4maha' -ew Iork Co""ins., 1>>9' Stee"e, Jay' Warren Buffett0 ,aster of the ,arket ' -ew Iork Har#er &a#erbacks., 1>>>' (rain, John' *he ,idas *ouch0 *he 1trategies *hat Have ,ade Warren Buffett merica%s Preeminent )nvestor ' De#rint ed' -ew Iork Har#erCo""ins., 1>99'
1
Case 1 +arren E' Bu$$et, 2005
E)hibit (2 -A$$( % &.//TT0 ,2
E)a!#"e o$ Co!#"eted ;DD Ana"ysis $or Berkshire Hathaway’s ;nvest!ent in MidA!erican - in !i""ions e)ce#t #er%share $iures.
Period Operatin5 $evenue and Other Income % Cost o$ sa"es and o#eratin e)#enses % @e#reciation and a!orti
n a ;nvest!ent
,1 8 40673% ,522'0 5>'0
,, 8 4063% ,0>2'0 50'0
,3 8 90143% ,>1'0 60'0
8
,4 907,7% 3,>0'0 69'0
8
61,% 63'9
8 10,:1% 512'3
8
109,7% 650'9
8
10966% 68>'6
Profit After Ta+ @e#reciation and a!orti
8
247%, 5>'0 9'0
8 79:%9 50'0 3,6'0
8
679%, 60'0 29>'0
8
1016%4 69'0 1'0
/ree Cash /lo; from Operations
25'2
-,063'3.
1,2>0'2
1,26'3
21,63
22,>60'5 19,39'2
Profit &efore Ta+ % (a)es L '''
30
1
(er!ina" va"ue
Total /ree Cash /lo; &er)shire
:%2= -1,632. 71%1=
25'2 20'9
-,063'3. -2,366'9.
1,2>0'2 1,09'6
1
(er!ina" Oa"ue N 4ree Ca sh 4"ow×-1.=-K e%.? assu!es rowth? and Ke can be esti!ated usin the CA&M, where the 0%year (reasury rate was 5'86 -see case $ ootnote 1., Be rkshirePs Beta is 0'85 - case $ ootnote 1. , and the "on%ter!, 'S' e/uity%!arket risk #re!iu! is 10'5 -see case $ootnote .? so, Ke N 5'86 0'85-10'5%5'86. N >'2'
KeN
Dis k%$ ree Da te
B er kshir e B eta
D isk #r e! iu!
Disk% $re e D at e
5'86
0'85
10'50
5'86
6%3,=