Case 1 Warren E.

Buffett, 2005 Assignment

Please make your answers as complete as possible by explaining/supporting the rationale
for your position.
1. What is the possible meaning of the changes in stock price for Berkshire Hathaway
and Scottish Power plc on the day of the acquisition announcement? Specifically, what
does the $2.55 billion gain in Berkshires market value of equity imply about the intrinsic
value of PacifiCorp?
a. The possible meaning of the changes in stock price is due to the fact that the deal
created value for both buyers and sellers; Berkshire was more diversified after the
acquisition.
b. The $2.55 billion gain in Berkshires market value of equity implied that the intrinsic
value of PacifiCorp was good because it fell within the range of competitors based on the
following calculations:

$2.55 billion / 312/18 million = $8.17 Berkshire is willing to pay this premium for
each share of PacifiCorp

5.1 billion / 312.18 million = $16.30 per share of PacifiCorp

$8.17 + 16.30 = $24.47 (see Exhibit 9)

2. Based on the multiples for comparable regulated utilities, what is the range of
possible values for PacifiCorp? What questions might you have about this range?

a. We find the range of possible values for PacifiCorp in Exhibit 10.

i. Revenue median of $6.252 Billion, mean of $6.584 Billion.

ii. EBIT median of $8.775 Billion, mean of $9.289 Billion.

iii. EBITDA median of $9.023 Billion, mean of $9.076 Billion.

iv. Net Income median of $7.596 Billion, mean of $7.553 Billion.

v. EPS median of $4.277 Billion, and a mean of $4.308 Billion.

vi. Book value median of $5.904 Billion, mean of $5.678 Billion.

b. Question about revenue; The implied value of PacifiCorp is giving impractical
results for range of revenue as compared to EBIT, EBITDA, & Net income (Expected:
Revenue > EBITDA > EBIT > NI).

3. Assess the bid for PacifiCorp. How does it compare with the firms intrinsic value? As
an alternative, the instructor could suggest that students perform a simple discounted
cash-flow (DCF) analysis.

If you use CAPM for the simple DCF analysis: K=rf+B(rm-rt)

rf=5.762 K=5.762+.75(10.5-5.762)

B=.75 =9.32%=Discount rate

rm=10.5

$5.1/(1+.0932)=$4.76 => it is in range of the rest of the comparable firms

4. How well has Berkshire Hathaway performed? How well has it performed in the
aggregate? What about its investment in MidAmerican Energy Holdings?

It has performed very well. Berkshire Hathaway has consistently outperformed the
market since its inception in 1965. In 1977, the firms year end closing share price was
$107; on May 24, 2005 the closing price on its Class A shares reached $85,500. Berkshire
has had an annual increase of wealth of 24% since 1965, which is more than double the
10.5% of the average increase for other large stocks. It started out with a decline due to
inflation, technological change, and intensifying competition from foreign competitors,
but has recuperated well after closing the textile side of their business.

Berkshire Hathaway had recently been performing below S&P 500 Index according to
Exhibit 1, from April 2005 to May 2005. Scottish Power had consistently outperformed
the S&P 500 Index from March to May 2005. This probably was one aspect that attracted
Berkshire to purchase PacifiCorp.

We believe that it was a good investment. In 2002 they owned 9.9% of the voting
interest and 83.7% of the economic interest in the equity of MidAmerican. This allows
them to have a major stake in the company without violating utility laws, which has
proven to be successful for them. According to Exhibit 6, MidAmerican Holdings had a net
earnings of 170 million in 2004, but compared to 2003 net earnings of 416 million,
MidAmerican had a net loss from 2003-2004. Acquiring PacifiCorp would supply much
needed new, more profitable investments to raise their net income in 2005.

5. What is your assessment of Berkshires investments in Buffetts Big Four: American
Express, Coca-Cola, Gillette, and Wells Fargo?

They invested in well established and successful firms. They put a lot of money up
front for these investments, but since have made substantial gains for their investment.
The total cost to Berkshires investment in the Big 4 was $3.832 Billion, but the market
value of their investment was $24.681 Billion. This means that Berkshires current gain on
their investment in the big 4 is $20.849 Billion. Their gain is 5.44 times their investment I
would have to say that these were very well thought out and successful investments.

6. From Warren Buffetts perspective, what is the intrinsic value? Why is it accorded
such importance? How is it estimated? What are the alternatives to intrinsic value? Why
does Buffett reject them?

a. The discounted value of the cash that can be taken out of a business during its
remaining life. Intrinsic value is per-share progress. Buffett assessed intrinsic value as the
present value of future expected performance.

b. Because if focuses on ability to earn returns in excess of the cost of capital, not
accounting profit. Only logical way to evaluate the relative attractiveness.

c. The gain in intrinsic value could be modeled as the value added by a business above
and beyond the charge for the use of capital in that business.

d. Accounting profit, performance of Berkshire by its size, consolidated reported
earnings

e. Accounting reality was conservative, backward looking, and governed by GAAP
(measures in terms of net profit). Investment decisions should be based on economic
reality. This includes intangible assets such as patents, trademarks, special managerial
expertise, reputation, etc.

7. Critically assess Buffetts investment philosophy. Be prepared to identify points where
you agree and disagree with him.

Warren Buffett has a very simple method of investment strategy compared to other
investors. Buffetts philosophy is defined in 8 elements. We will discuss whether we
agree or disagree with each one individually. We agree with Buffetts first element of
analyzing economic reality of investments. Most investors focus on financial statements
and net profit, but dont take into consideration intangible assets such as management
experience and patents.

We also agree with Buffetts second element of lost opportunity cost comparison. By
analyzing expected returns of an investment compared to the rate of return of using that
same investment money in another investment, Buffett takes a simple idea that everyone
uses in almost every decision, and applies it to a much more complex investment strategy.
Everyone weighs the alternative when making a decision, whether that decision is a
choice of a coffee or a coke or something more complex like a college education versus
not getting an education.

Buffett uses the third element of intrinsic value instead of book value or historical
data to determine his investment choices. We agree with this element, but do believe
a combination of the two methods would work better to show historically how the
company has performed, and how much that company will be worth in the future.
The rate of return reflects more of the economic value of an investment.

In the fourth element, Buffett measures performance by per share basis. We do agree
with his reasoning for using this method, but we think overall performance should be
measured as well to show a better figure of what the whole is worth compared to the
parts.

The fifth element is one that we dont agree with. Buffett uses a 30 year U.S. Treasury
Bond Rate of Return instead of the traditional CAPM rate, because he believes that his
investments are so solid, they dont need risk factored in. We disagree with his choice
for rate of return because all investments have a degree of risk, and return should
be factored according to that level of risk. Buffett not believing in risk is like someone
not believing we breathe air. Even though we cant see it, it is still there.

The sixth element is also a point of disagreement for me. Buffett says he doesnt
believe in diversification of investments, even stating that diversification is considered
protection against ignorance. What Buffett does not realize is that by saying he does
not believe in diversification, he is being a hypocrite. Berkshire Hathaway itself is a
massively diverse company with several subsidiaries and holdings in many different
industries from apparel to energy. Buffett may own most of his stock in his own
company, but he knows by diversifying Berkshire, he will avoid adding more risk,
which is exactly the strategy that is used by other investors when diversifying their
stocks.

We agree with the seventh element that investment decisions should be made by
doing proper research on information about the company, and not by following an
anonymous tip or a gut feeling.

Finally, we agree with the eighth element that a firms management and shareholders
should have the same goals for the firm. Management should have most of their wealth
in company stock so as to serve the shareholders better in day-to-day decision making
that affects the value of their investments.

8. Should Berkshire Hathaways shareholders endorse the acquisition of PacifiCorp?

Yes, PacifiCorp will add around $250 million in net income for MidAmerican Holdings if
PacifiCorp keeps at its same net income pattern of the last two years. This added net
income will increase shareholder wealth in Berkshire Hathaway and provide a stable long
term investment for the future. Also, since PacifiCorps intrinsic value is comparable to
the industry, Berkshire is not adding much more risk to their portfolio. Berkshire should
look at adding more of these type safer investments to their portfolio.

Notes
Warren E Buffet
Potential
Economic rality, not accounting
Cost of opportunity


Value of a Stock
Representation of a regular-sized part on a firms equity (capital social = equity)
# Of stock = 100,000
Firms equity = $1, 000,000
Stock Price = $10

- Variarion on Price related to offer and demand (puclic stock)
Excess on demand imply an overvalued stock
Expectations

Present Value of Future Incomes


1. Value of Pacific Corp before any anoucement of adquisition

2. According to this information is Warren Buffet overpaying for the value of Pacific
corp



Pacifics Corp Value
$ 4.2 - $ 4.3 billions

Berkshires bid
$ 5.1 billions
12 - 18 months Federal annual state regulatory reviews

Ke = Rf + B (Rr- Rf)

Rf = 5.76 %
B(beta) = 0.75
Rr = 10.5% (nota de pie de pgina 3)

Ke = 5.76% + 0.75(10.5-5.76)

Ke = 9.32%

5.1/(1+0.0932) = 4.76 billions (actual value)

Berkshire is overpaying

Terminal Value = Free Cash Flow
1 + g
Ke - g

g = 3%

(1+0.03) / (0.0932-0.03)
1.03/0.0632

IRR
Initial Inv. 1,642
CF 2001 203.8
CF 2002 -2466.8
CF 2003 1038.6
CF 2004 18,483.2

IRR = 71.1%