Warren E. Buffett is one of the world’s richest men with a net worth estimated at $44 billion by Forbes magazine. Buffett is known for his patient approach to investing and making long-term investments in steady, predictable industries that generate positive cash flow. It was announced that MidAmerican would purchase the regulated electric utility PacifiCorp from Scottish Power, for $5.1 billion in cash and $4.3 billion in liabilities and preferred stock. This would be the second largest purchase of his career. After the announcement, stock prices for both PacifiCorp and Berkshire Hathaway increased, by 2.4% and 6.28% respectfully, which suggests market approval for the acquisition of PacifiCorp.
From the increase in stock price, we can assume that investors believe that the deal was a fair price and that acquiring PacifiCorp was a good investment to benefit Berkshire Hathaway. In fact the market added more value enhancement to Scottish Power than Berkshire, which leads investors to consider why Scottish Power gained more benefit than Berkshire Hathaway and if Berkshire Hathaway paid a reasonable price.
From Exhibit A, on the following page, we can analyze the range of values for PacifiCorp. From this we can see that the only significant various between median and mean value arises in EBIT, which indicates outliers for revenues, operating expenses, or depreciation. Intrinsic value refers to the actual value of a company or stock without reference to its market value and is calculated through the discounted cash flow of a business during its remaining life. Intrinsic value can also encapsulate how well the company is run, cash flow, and management competency. According to Buffett, intrinsic value indicates the “present value of the future expected performance” and can be predicted through calculating the discounted cash flow of a business for its remaining life. This estimate allows Buffett to identify stocks or businesses that are undervalued. Other alternatives to intrinsic value as book value and accounting profit, which can fall short when determining what the investment is really worth and accurate aggregate value.
Stock price is the most accurate way to determine a company’s present value of expected cash flows. However, as a private company, the market value of PacifiCorp could not be determined by its share price. In order to calculate Berkshire’s discount rate we must use the capital asset pricing model (CAPM) to determine a required rate of return. This is calculated by adding the risk free rate (yield on a U.S. Treasury Bond) to beta multiplied by the difference of the expected market return and risk free rate. A U.S. Treasury Bill has a yield of 5.76%, Berkshire’s beta is .7, and expected market return is 10.5%, therefore the rate of return would be 9.07%. This can then be used to determine the present value of this investment over one year, $4.68 billion. Therefore, Berkshire’s offer to purchase PacifiCorp for $5.1 billion is slightly overvalued, but still a fair price for both companies.
Berkshire Hathaway performed tremendously well between the periods of 1965 and 1995, where its stock prices grew 24%, in comparison to the S&P 500, which averaged 10.5% a year. This is a remarkable occurrence to beat the market growth rate, and is even more rare to beating it for 30 consecutive years. Berkshire’s shares have been among the highest-priced shares on the New York Stock Exchange. Berkshire also holds majority shares in Coca-Cola Co., American Express Co., Gillette Co., and Wells Fargo, all of which have had consistent growth and stability over the companies’ lifetime.
Buffet’s philosophy contradicts many of the common principles the average investor swears by. His philosophy relies on little diversification and avoiding risk. The biggest stand out in this regard is his dislike of broad diversification. Instead referring to diversification as protection against ignorance and an unstable market, Buffet believes it to be the lazy way out. Buffet believes that we must invest in our expertise areas and therefore will have greater knowledge in a handful of stocks and should not diversify our portfolio by purchasing shares of companies we know nothing about. While I understand where Buffet is coming from, this seems very risky.
This case shows a prime example of the link between a company’s valuation and the behavior of investors in the capital market. Through Berkshire Hathaway`s increase in share price the investors reflected that they agreed with the deal through an increase in share price. And even though it seems odd that both the selling and buying company should have an increased share price, we can see through calculating PacifiCorp’s intrinsic value, that the purchase was reasonable. This acquisition also added more diversification to Berkshire’s investment portfolio to provide more stable returns.