Case Study Report– Warren E. Buffett, 2005
Ankie Wong Benny Cheng Christine Wai Chris Tam Jacky Chan Veronica Chang
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In this case study, we attempt to study an investment Guru, Mr. Warren E. Buffett, through (1) evaluating his 2 major investments - acquisition of PacifiCorp. in 2005 and the ‘Big Four’ (2) investigation and critical analysis of his 8 major investment philosophies and other important ideas such as intrinsic value, valuation of stocks and time value of money. I. Acquisition of PacifiCorp..
On May 24, 2005, it was announced that MidAmercian Energy Holdings Company, a subsidiary of Berkshire Hathaway, would acquire a private energy company, PacifiCorp., whose parent,
Scottish Power, is a listed energy company PacifiCorp.. Berkshire has utilized $5.1 billion in cash, which will be paid after 1 year, together with further liabilities to complete the acquisition. The market responded very positively on the same day. As illustrated in figure 1, Berkshire’s stock price has been increased by 2.4%, which PacifiCorp.’s parent, Scottish Power’s by 6.28% and S&P 500 closed up 0.02%. We believe there are 4 possible reasons for such a response: a) Psychological factor- The general public believed Buffett is an investment guru rather than rationally studying market information of the acquisition. b) Higher Return on Equity (ROE) ratio of Scottish Power (PacifiCorp.) than Berkshire (7.5% vs. 5.7%) c) Outperformed stock price of Scottish Power (PacifiCorp.) than the market while Berkshire was underperformed. 2
d) More diversified investment portfolio of Berkshire after the acquisition was expected to provide more stable returns. Before the acquisition, Berkshire did not have significant investment in energy sector. Using Intrinsic Value concept to evaluate the acquisition The positive market response had provided Berkshire a gain of $2.55 billion in market equity value. We can hence apply the intrinsic value concept and evaluate if Buffett paid higher or lower than the market price for PacifiCorp.. Buffett defines intrinsic value as ‘discounted value of the cash that can be taken out of business during its remaining life.’ He actually paid $4.67 billion for PaciCorp. (i.e. his intrinsic value of PacifiCorp. before the announcement) It is calculated by discounting the $5.1 billion cash paid for 1 year at a discount rate of 9.315%. And the rate is obtained by using capital asset pricing model (CAPM). It was given that yield on the 30-year US Treasury bond (i.e. risk free return rate) on the announcement day was 5.76%, Berkshire’s beta was 0.75 and annual average total return on all large stocks from 1965 to the end of 2004 (i.e. market return) was 10.5%. Therefore, market price of PacifiCorp. was $7.65 billion (which comprised of the $5.1 billion cash & $2.55 billion gain) at closing of May 24, 2005. However, Buffet was actually paying lower. His intrinsic value was only $7.31 billion (which comprised of the discounted value of $4.67 billion and $2.55 billion gain) Another way – Using Financial Multiples Besides looking into the intrinsic value implied by the response from the market, we can also 3
use the financial multiples (i.e. Price to Earnings and Book Values) of other companies in the same industry to estimate the possible value of PacifiCorp.. 5 Comparable Regulated Energy Firms were selected to benchmark the value of PacifiCorp., namely Alliant Energy Corp, Cinergy Corp. NSTAR, SCANA Corp and Wisconsin Energy Corp. a) Price to Earnings By using the net income and shares outstanding provided, we can obtain the earnings per share of these 5 firms. With earnings per share, we can estimate the possible range of price to earnings of the utilities industry. Table 1 shows how it works and the results told the range will be from 11.28 to 20.33. Hence, we can estimate the stock price of PacifiCorp. to be...