a)From Warren Buffett’s perspective, what is the intrinsic value? Intrinsic value is succinctly summed up by Warren Buffett as “the present value of future expected performance” (Bruner, Eades, & Schill, 2009). This intrinsic value can encapsulate how well the company is run, its cash flow and places a premium on management competency. Why is it accorded such importance?
Intrinsic value is considered important in value investing as it allows Buffett to identify stocks or businesses which are undervalued. This is important as “intrinsic value is the value of a company's business, not its stock” (Carbonara, 1999). How is it estimated?
Buffett readily admits that intrinsic value is highly subjective (Bruner et al., 2009). Buffett’s method is to estimate ‘discounted cash flows’ (Carbonara, 1999). This is similar to the NVP, of a business cash flow, discounted to today’s value to obtain an estimated intrinsic value. Though it is an estimate, this does not bother Buffett as he stated that “it is better to be approximately right than precisely wrong” (Bruner et al., 2009). What are the alternatives to intrinsic value?
An alternative to intrinsic value is book value or accounting profit. That is instead of investing based on the company book value or accounting statements instead. Why does Buffett reject them?
Buffett rejects these alternatives as he emphasizes “economic reality, not accounting reality” (Bruner et al., 2009). Book value is useless as a determinant of intrinsic value as it does not fully reflect the relationship between rates of return and the required rate of return. Typically book value is considered to be historical input whereas intrinsic value is the measure of future output (Bruner et al., 2009). b)Critically assess Buffett’s investment philosophy. Be prepared to identify points where you agree and disagree with him. Buffett’s mantra is that “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price” (Robin, 2008). This is an easy philosophy to follow as; buy low, sell high is one of the main tenets of investing. Conversely, in terms of diversification, Buffett’s philosophy runs against the grain of conventional finance. It is a point I agree with. Overly trying to reduce risk by diversification can cause you to inversely miss the trees for the forest and miss out on promising investment opportunities. Herein lays a problem. As Buffett avoids risks in investment he passes up major opportunities by being overly prudent. He insists on investing in elephants while simultaneously shunning technological companies. As of present, he still refuses to invest in the dotcom bubble, anticipating it will burst again (Independent, 2011). Lastly, I believe Buffett’s emphasis on awareness and information as the foundation for investing over emotion driven investing (Bruner et al., 2009) as invaluable.
c)Should Berkshire Hathaway’s shareholders endorse the acquisition of PacifiCorp? As Buffett is well known to be a socially responsible investor, shareholders should welcome the investment. Also this acquisition could be reactive, as Duke Energy was bidding for Cinergy for $9 billion (Bruner et al., 2009). Buffett may not have wanted to lose market share in the energy sector while also creating value for shareholders by acquiring a company that is profitable. Shareholders should endorse investments in the energy sector even though it is unglamorous and highly regulated because it has steady returns (Timmons & Mouawad, 2005) and consequently increases price-per-share. Still, as we go back to intrinsic value, Buffett looks favourably on PacifiCorp “…it's a capital- intensive business that provides decent returns. It's stable and it's predictable" (Timmons & Mouawad, 2005). Also, as Berkshire Hathaway’s main sector is insurance it is ironic that investing large in the energy sector creates value through diversification.
CASE 2: Bill Miller and...