Capital Market Warren E Buffet Case Report Assignment

Syndicate YP47B: Adilla Nurlina Ayu Eka Putri Dwi Kurnia Putri Indri Yul Avianti Siti Larissa Sarasvati Yara Putri Genevera Yulianita Rahayu

Master of Business Administration School of Business and Management Institut Teknologi Bandung 2013

Case Overview This case took place in 2005 and speaks about Warren Buffets acquisition of PacifiCorp (subsidiary of Scottish Power) for $5.1 billion in cash and $4.3 in liabilities and preferred stock. Back then; Buffet was the CEO of Berkshire

Hathaway, which is a corporation that dives into various industries and business activities. Their business is ranging from grocery distribution to flight services. Apparently, it appeared that they wanted to broaden their portfolio by acquiring PacifiCorp, an electric utility company that provided a low cost energy to 1.6 million in six states on the west coast. In accordance with the announcement of the acquisition, Berkshires stock price has been increased by 2.4% (equivalent to $2.55 billion) and on the other hand, Scottish Powers also increased by 6.28% and S&P 500 closed up 0.02%. Furthermore, Warren Buffet also invests in several large companies, such as American Express, Coca-Cola, Wells Fargo together with Gillette and referred those companies as Berkshire Hathaways Big Four. In addition to the details concerning Berkshires business activities, this case also highlighted Warrens investment philosophies, which summarized into eight points that are the concept of economic reality, the cost of lost opportunity, value creation (time value of money), measuring performance in intrinsic value, risk and discount rates, diversification, investing behavior, and the arrangement of agents and owners.

In the end, there are numerous problems and questions brought by this case, such as whether the PacifiCorp acquisition will serve the long-term goals of Berkshire Hathaway or whetherthe bid price is also appropriate, and what is the explanation for Berkshire increasing share price at the announcement. Furthermore, as Scottish Power privately held PacifiCorp, how did Berkshires offer measure up against the companys valuation implied the multiples for comparable firms.

Objectives In accordance to this case, we attempt to study Mr. Warren Buffett, the "Oracle of Omaha that has reached the summit of business excellence and has become the most judicious financial investor through:

1. Analyzing his investment activities, such as the acquisition of PacifiCorp and Big Four, 2. Exploring his eight investment philosophies.

Analysis

I.

Acquisition of PacifiCorp

On May 24, 2005, Warren Buffett announced that MidAmerican Energy Holdings Company (Berkshire Hathaways subsidiary) would acquire and electric utility company, PacifiCorp whose parent Scottish Power. Berkshire has utilized $5.1 billion in cash, which will be paid in the next 12 to 18 months, together with $4.3 liabilities and preferred stock to complete the acquisition.There are several questions arise regarding the acquisition, which are:

a. What might account for the share price increase for Berkshire Hathaway at the announcement?

When a firm acquires another entity, there usually is a short-term effect on the stock price of both companies. As described in the Exhibit 1, we can see that either Berkshires and Scottish Powers stock price has been increased due to the acquisition announcement. This happened to be a positive respond from the market (market approve for the acquisition). Furthermore, we consideredthat the major motivation to this respond is apparently psychological; where public tend to trustBuffetts movements as he already known with his excellent record on investment. Evidence on Buffets remarkable ability can simply be found in the case. First of all, this case mentioned that Berkshire has 24% compound stock prices annual growth, while large firms averaged growth is 10.5% per year over the same period, which is1965 to 1995.This comparison shows that Berkshires performances have been outstanding. The second one is regarding Berkshires equity investing activities, where Buffet acquired many large companies; some of those acquisitions called Berkshire Hathaways Big Four; namely American Express, Wells Fargo and Gillette together

with Coca-Cola. According to Exhibit 3, we may see that Buffets criteria seem to be consistency of companys operation history, quality of the companys capacity in order to create value, and attractiveness of long term prospects. Most of the company has a very outstanding performance as it shown in the exhibit. The third one is the Berkshires investment in MidAmerican. We perform a simple analysis of Berkshire ROI. The calculation obtained from the data that provided in Exhibit 6.

Table 1.1 IRR Analysis of MidAmerican

Table 1.1 show us the calculation of IRR, where it can be obtain by computing Berkshires share of MidAmericans free cash flow. In order to derive the terminal value, we have to calculate terminal free cash flow using CAPM and growth rate at 3%, which CAPM Beta Risk-free rate Market Risk Premium Cost of Equity Figure 1. CAPM 0.57 5.76 10.5% 9.32%

The final result shows us that Berkshire return on its investment in MidAmerican is 71%, which happened to be a very large return. Furthermore,in

February 2005, Warren Buffet also announced as one of the richest people in the world by Forbes. 1

b. Was the bid price is appropriate?

In order to respond to this question, we will look at two things, which are companys intrinsic value and Companys valuation implied by the multiples for comparable firms. Intrinsic value of PacifiCorp

Intrinsic value is the present value of the future expected performance of a firm. Warren Buffet considers this is one of the most important tools in investment. Here is our calculation on intrinsic value: Step 1 : Calculating CAPM (see Figure 1)

Step 2 Berkshire Hathaway

: Calculating the present value of the initial investment of

a. Companys valuation implied by the multiples for comparable firms Because PacifiCorp was privately held by Scottish Power, which means that PacifiCorp does not pay dividend. Companys valuation implied by the multiples for comparable firms is more reasonable method than using market value. Exhibit 9 and exhibit 10 present implied valuations for PacifiCorp using averages and medians of those firms multiples.
Enterprise Value
(in million dollars)

Alliant Cinergy NSTAR SCANA Wisconsin PacifiCorp Median Mean

$ 5,600 $ 13,231 $ 5,287 $ 7,967 $ 7,691 $ 6,252 $ 9,289 $ 7,691 $ 7,955

Figure 2. Enterprise Value multiples based on the performance of comparable firms

1Forbes. (2005). World's Richest People. Available:

http://www.forbes.com/static/bill2005/LIRC0R3.html. Last accessed 29 Aug 2013

MV Equity
(in million dollars)

Alliant Cinergy NSTAR SCANA Wisconsin PacifiCorp Median Mean

$ $ $ $ $ $ $ $ $

3,333 7,989 2,898 4,486 4,048 4,277 5,904 4,048 4,551

Figure 3. Market Value multiples based on the performance of comparable firms

Figure 2 shows enterprise value multiples of comparable firms, the bid price derives from the table should be around $6,252 to $9,289 but Berkshires offers $9.4 billion to acquire PacifiCorp. Using this method apparently the bid price is not appropriate, Berkshires offers measure is overvalue even though the enterprise value of PacifiCorp is above the enterprise values mean and median of comparable firms. Based on exhibit 9 and exhibit 10 Cinergy Corp is the most valuable firm of comparable firms and the most similar firm as Duke Energy had acquired PacifiCorp, in a $9 billion stock swap. The market value multiples of comparable firms showed by figure 3, PacifiCorp market value of equity is around $ 4,277 to $5,904. If Berkshire offers $5.1 billion cash to acquire PacifiCorp Equity and the deal will take 12 to 18 months the present value of Berkshires offer will be $4,665 million. Berkshire might be gain equity value from the acquisition about $1,239 million. Discounted Cash Flow Another private firm valuation method is Discounted Cash Flow. Discounted Cash Flow indicates the net present value from our investment discount at some required return of the firm. The required return of the firm can be found by calculate the Weighted Average Cost of Capital (WACC). In order to find the WACC value of PacifiCorp, there are some components of the firm cost of capital that need to be calculated first, which are cost of debt, cost of equity, or cost of preferred. This WACC value indicates amount of return that the firm has to pay as the result caused by financing the company.

Assumption Refference: D+E D E D/(D+E) E/(D+E) Interest Rates Cost of Debt Rf Rm Beta PacifiCorp Cost of Equity WACC Expected Growth: Sales Expenses Shareholder Wealth Intrinstic Firm Value Tax

9400 4300 5100 46% 54% 7% 4% 6% 11% 0.77 9% 8% 12% 10% 24% 15% 40%

pg 1 pg 2 pg 3

Exhibit 7 Footnote Footnote Exhibit 9

pg 13 pg 13

1) Cost of Capital Estimates Calculation Cost of Debt PacifiCorp. Interest Rates of PacifiCorp is 7% which can be found using Income Statement of PacifiCorp on Exhibit 7. Cost of debt is interest rates multiply by earning after tax rates.

Cost of Debt = before-tax-cost of debt * (1-T)

The tax Rate is 40%, so PacifiCorp cost of debt is 4%. Tax Rate 40% Rd 7% COD 4% Cost of Equity

Cost of equity can be found using the CAPM formula. The components of the CAPM formula are Risk free rate which is according to the Gitman text book usually the short-term treasury bills, market required return of equity, and risk premium is different amount of risk market return and risk free rate.

Cost of Equity = Rf + (*(Risk Premium)

Cost of Equity = = 6% + (0.77 x (11%-6%)) 9%

The risk premium is market required return of equity distract by risk free rate. PacifiCorp cost of Equity is 9%. Weighted average cost of capital (WACC) In this case Berkshires offer $9.4 billion to acquire PacifiCorp. This payment consists of $5.1 billion in cash and $4.3 in debt and preferred stock. Target level of debt-to-asset ratio in acquiring the plant is 46% to calculate cost of capital. Therefore the equity-to-asset ratio is 54%.

WACC = D/V*After-tax cost of debt + E/V*Cost of equity

WACC for PacifiCorp cash flow is 8%. This cost of capital will be used to calculate Net Present Value of the investment. 2) Calculating NPV The result of the NPV on the basis of the current cash flow provided in appendixes in this paper and information provided in case material. This calculation used data in Exhibit 7 as comparison and projected cash flow from 2006 to 2013 based on assumptions as stated before. The Net Present Value of PacifiCorp Acquisition is $9257 million. The Discounted Cash Flow method showed that a bid for PacifiCorp of $9.400 million will create $9257 million net present value and on the announcement day Berkshire gained $2.55 million in market value. The bid price is appropriate because Berkshires offer according to discounted cash flow method will generate positive intrinsic values for the company. This method is radically different from current, implied, and expected values for comparable firms. According to their acquisition criteria released in the 2004 annual report PacifiCorp meets at least 5 of the 6 principles needed. They are considered a large purchase with pretaxearnings at $656 million and have positive earnings growth over the last two years (only two years of data available). PacifiCorp already has management in place with steady growth meaning it would be simple for Berkshire Hathaway to take over without large amounts of restructuring. In addition to the beneficial, qualitative factors of PacifiCorp, the companys fundamentals prove the company will be a successful investment. Referring to Exhibit 10 in the case, looking at its relative enterprise valuation based on operating measures (e.g., revenues, operating profit, and net income), it yields an average enterprise value of $8.015 billion, which is higher than its primary competitors. Also, when comparing

PacifiCorps average relative valuation of expected market value it yields $5.042 billion, better than the firms primary competitors average of $4.551 billion by 11 basis points. Buffetts Investment Philosophy

II.

Buffetts persona in the world of investments has been uncomparable. His investment principles have stood the time and often used by many investors. Buffets principles are actually simple, easy to be understood and followed. Basically, this gurus character is conventional as he saw prospects of an investment in the long-term perspective and his success is a combination of careful calculation, courage and patience. In the following, we will provide our assessment towards the philosophies.

1) Economic Reality; not accounting reality We believe this first philosophy is by far the most important and may differ Buffet with any other investor. He stated that financial statements prepared by accountants conformed to rules that might not adequately represent the economic reality of a business, as accounting reality was conservative, backward looking, and governed by GAAP. Warren Buffett also defined economic reality at the level of business itself, not the market, the economy, or the security. In conclusion, what we have studied from this philosophy is we should take into account many aspects in considering an investment, just like Buffet that uses 12 investing tenets or key considerations, which are categorized in the areas of business, management, financial measures and value.2

2) The cost of lost opportunity In his investment decision-making process, Buffet always compares his choice with another best opportunity. Actually, comparing one choice against another seems ordinary, but what we found interesting here is that Buffet considering the cost of loosing the other opportunity. In this case, we took that Buffer saw the true cost of an investment is what you give up (opportunity) to get it. This includes not only the money spent in buying that asset but also the economic benefits that one has to do
2Investopedia.

(2011). What Is Warren Buffett's Investing Style?. Available: http://www.investopedia.com/articles/05/012705.asp. Last accessed 29 August 2013.

without because one bought that particular asset and thus can no longer buy something else with that money.

3) Value Creation: Time is money Warren Buffett defined intrinsic value as the discounted value of the cash that can be obtained from a business during its remaining life. Buffet calculates the value of a business as the net cash flows expected over the life of the business, discounted at an appropriate interest rate. Net cash flows are companys owner earnings over a long period. Something like the thirty-year U.S. Treasury bond rate can beused as a measure of the interest rate for this calculation.Thediscounted cash-flow approach is veryconservative as long as an appropriate discount rate isapplied. In spite of its uncertainty, intrinsic value is important because we cant deny that book value is actually meaningless in relation with future potential growth. Therefore, the lesson that we can obtain from this third philosophy is we should really pay attention to the business future potential growth, not the amount of investment that we put.

4) Measure performance by gain in intrinsic value, not accounting profit Warren Buffetts long-term economic goal is to maximize Berkshires average annual rate of gain in intrinsic values with per-share basis. He does not measure the economic significance or performance of Berkshire by its size, but by per-share progress and he will be disappointed if the rate of per-share progress does not exceed that of the average large American corporation. According to this philosophy, we believed that gain in intrinsic value being referred to is similar to EVA (Economic Value Added) or Market Value Added measures. These measurement focuses on the ability to earns returns in excess of the cost of capital. The difference between a company's return and its cost of raising capital is called "EVA" (Economic Value Added). Unlike traditional accounting measures, (EPS and ROI), EVA focuses on economic profit to capture the true performance of a company. In other words when we measure performance by gain in intrinsic value we are estimating the amount by which earnings exceed or fall short of the rate of return shareholders and lenders could get by investing in other securities of comparable risk. Furthermore, we believe even though intrinsic value is a key pillar, accounting profit is also necessary to be assessed as it also reflects the quality of a company.

5) Risk & Discount Rates Conventional Warren Buffett defined risk as the possibility of loss or injury. His company used almost no debt financing. To avoid risk, he also put a heavy weight of investments on certainty by focusing on companies with predictable and stable earnings. Thus, the idea of a risk factor does not make sense to him so that he utilized a risk-free discount rate such as the rate of return on the long-term (for example, 30year) U.S. Treasury bond. We believe, here one would disagree with Buffett. In the world of finance, risk and return is one of the basic principles, where its related to one another as we often heard, the greater risk the greater the return. There are also many risks, which cannot be completely avoided and predicted, such as natural disasters, wars and political events. Even though Warren Buffet known as the Oracle of Omaha, he happened to be a normal person with great ability, not a fortuneteller. Therefore it is not prudent to discount all future cash flows at the risk free rate and we cannot ignore existence of risk and should not use risk free rate to get intrinsic value, which the return of investment will be overvalued.

6) Diversification Warren Buffett suggested that investors typically purchased far too many stocks rather than waiting for one exceptional company. Investors should pay attention to only businesses that they understand. This principle sometimes misunderstood, that Buffet is somehow anti diversification. Actually, from our point of view the means of this philosophy is an investor should understand a companys operating fundamentals, where they need to adopt the concept of intelligent investing. Investor should act like the owner of the business, not the owner of a piece of paper. In this case, very few business owners are comfortable and have the ability to operate a number of companies at the same time, therefore, Buffet believed that it is not necessary to diversify if the objectives is only for spreading away investment risks. In conclusion, we have learned that diversification will be much better if its accompanied with deep understanding on the business itself.

7) Investing behavior should be driven by information, analysis & self-discipline; not by emotion or hunch Instead of following Mr. Markets opinion, it would be wiser for investors to form their own ideas of the value of their holdings, based on full reports from the

company about its operation and financial status. Warren Buffett did not believe in the stock market. When he invested in stocks, he invested in businesses. He behaved according to what is rational rather than according to what is fashionable. He didnt try to time the market (trade stocks based on expectations of changes in the market cycle). Instead, he employed a strategy of patient, long-term investing. In conclusion, we can learn that it is essential to use intellect not emotion when investing.

8) Alignment of agents & owners Warren Buffett claimed, He is a better businessman because he is an investor. And he is a better investor because he is a businessman. More than 50 percent of the family net worth of four of Berkshires six directors contained shares in Berkshire Hathaway. Moreover, the senior managers of Berkshire Hathaway subsidiaries held shares in the company, or were compensated under incentive plans that related to the potential returns from an equity interest in their business unit.

The lessons that we can take from this philosophy is that: Spend wisely Overcome your fear of risk Focus on the long term Invest in quality business Sell losing stocks when the market is up, buy winning stocks during a crash Make decisions to invest based on how well money is being used by company management

Conclusion Bakshire should acquired PacifiCorp for a bid price of $9,400, even though PacifiCorp valuation using Multiples valuation of comparable firms showed that a bid price of PacifiCorp for $9,400 million according to this method is not appropriate and Bekshire would not get any intrinsic value. The second method, which is discountedcash-flow method calculate the future benefit of the investment (intrinsic value). The NPV of investment is $9,257, so bid price according to discounted cash flow method is appropriate and Bekshire will generate intrinsic value which is almost twice

Bekshires offer. Even more record of Warren E Buffet in investment world have been outstanding, some of them is The Successful of The Big Four. In the

announcement day, the share price both of Bakshire and Scottish Energy is increasing. Which indicates a positive respond from the market (market approve for the acquisition). So Bakshires should acquire PacifiCorp, and bid price of $9,400 is appropriate. The successful of Warren E. Buffett is a combination of a good calculation, the courage, and patience in investing in the right time. Patience is important to buy stocks. The right time to buy stocks according to Warren Buffett is when stock prices decline massively. Period collapse in the stock market is often responded by market participants with a sense of fear and panic. In fact, the crisis in the stock market can give us a gold opportunity to gain profit on stock investments. When the collapse occurs in the stock market, then you will receive shares of good companies at super discounted prices. Buffet character in investing is by look at the prospect of an investment in the long-term perspective. Discounted price by Warren Buffet is not only in nominal terms, but also discounted valuations.