Case One: Warren Buffett
From Warren Buffett’s perspective, what is intrinsic value? Buffett defines intrinsic value as “the present value of future expected performance” or “”the cash that can be taken out of a business during its remaining life” (Bruner 2010). It is a subjective value based on the analysts’ estimates of future cash flows and interest rates.
Why is it accorded such importance?
It identifies mispriced shares and whether or not “an investor is indeed buying something for what it is worth” (Bruner 2010). Eventually market price will gravitate towards the intrinsic value.
How is it estimated?
By discounting the future cash flows that the business is expected to produce. Buffett uses the thirty year U.S. Treasury bond yield as the discount rate.
What are the alternatives to intrinsic value?
Alternatives to intrinsic value are book value and accounting profit.
Why does Buffett reject them?
Buffett believes the alternatives do not include future forecasts of earnings and therefore economic reality. The alternatives do not tell an investor if the estimated future rates of return exceed or are below the required rates of return. Buffett believes that accounting statements are “conservative, backward-looking, and governed by GAAP” (Bruner 2010) and does not reflect qualitative business assets such as intangibles or management skill.
Critically assess Buffett’s investment philosophy. Identify points where you agree and disagree with him. Valuing a share based on its relative performance to similar shares is an invaluable strategy to ensure the maximum return on investments. Accounting profit should be used in tandem with intrinsic value as it helps to assess the skill with which management is putting capital to use Accounting profit doesn’t reflect human capital though economic reality doesn’t reflect financial health. Buffett’s advice on investing based on sound research and a detached emotional state, rather than being an emotional slave to day to day price fluctuations is sound. Buffett’s heavy focus on economic reality relies too heavily on subjective evaluation of intangible assets. Future cash flows and discount rates are difficult if not impossible to estimate. Risk is unavoidable and although extensive research can limit the risk, some will always exist. Denying this fact will lead to overvaluation of stocks discounted at too low a rate. It is important to match the discount rate used to the investment strategy you employ as Buffett has done ie: minimising risk through extensive research and hands on involvement in firms that he invests in. This extends to his minimum diversification strategy which allows minimal trading and research. A hands on approach, and never investing in firms he does not understand leads to more accurate estimates.
Should Berkshire Hathaway’s shareholders endorse the acquisition of PacifiCorp? Why? The PacifiCorp acquisition is a good match for BH’s investment strategy. BH now requires large “elephant” investments to increase its net worth. PacifiCorp meets this requirement while also showing strong profitability and consistent, revenues from the predictable energy industry. It helps to increase BH’s intrinsic value on a per share basis by 2.4%, which is the firms stated goal. The market believed they were adding intrinsic value over the cost paid.
Case Two: Bill Miller and Value Trust.
How well has value trust performed in recent years?
Value Trust heavily invested in financials and stocks linked to the US housing market. This lead to heavy losses during the GFC. Once the crisis hit Bill Miller failed to realise its seriousness by doubling down. The fund has trailed the S&P500 for the last 6 years. It lost $18 billion in assets since 2006 shrinking from $20.1 to $2.8 billion. Its annual losses are 6.9% with a cumulative loss of 30.1% up to march 2012. In the same period the S&P500 had annual returns of 2.01% and cumulative returns of 10.48%...
References: 1. Bruner, Eades, Schill, 2010, Case Studies in Finance – managing for corporate value creation, McGraw-Hill/Irwin, New York. Case one & two, p 3- 38.
2. Light, Lauricella, “A Star Exits after Value Falls”, The Wall Street Journal, Nov 18 2011, viewed 09/09/2012, <http://online.wsj.com/article/SB10001424052970203611404577043910758867408.html>
3. Armstrong, Bill Miller’s Unglorious End Points Out Dangers Of Running With The Crowd”, Forbes, Jan 5 2012, viewed 08/09/2012, <http://www.forbes.com/sites/greatspeculations/2012/05/01/bill-millers-unglorious-end-points-out-dangers-of-running-with-the-crowd/>
4. Reem Heakal, Sept 19 2009, What is Market Efficiency?, Investopedia, viewed 07/09/2012, < http://www.investopedia.com/articles/02/101502.asp#axzz264WHy1K4 >
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