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1 page, case 1 Warren E. Buffet, 2015(page 64)Did Buffett pay a fair price for a great business? If so, what determines a fair price? How is required rate of return related to determining a fair price?How did Berkshire Hathaway’s offer measure up against the company’s valuation implied by the multiples for comparable firms?In comparing accounting
ratios year over year, are we ignoring time value of money? Explain
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CASE
Warren
E. Buffett, 2015
1
On August 10, 2015, Warren E. Buffett, chair and CEO of Berkshire Hathaway Inc.,
announced that Berkshire Hathaway would acquire the aerospace-parts supplier
Precision Castparts Corporation (PCP). In Buffett’s largest deal ever, Berkshire would
purchase all of PCP’s outstanding shares for $235 per share in cash, a 21% premium
over the trading price a day earlier. The bid valued PCP’s equity at $32.3 billion.1 The
total transaction value would be $37.2 billion, including assuming PCP’s outstanding
debt—this was what analysts called the “enterprise value.” “I’ve admired PCP’s
operation for a long time. For good reasons, it is the supplier of choice for the world’s
aerospace industry, one of the largest sources of American exports,”2 Buffett said.
After the announcement, Berkshire Hathaway’s Class A3 shares moved down 1.1% at
market open, a loss in market value of $4.05 billion.4 PCP’s share price jumped
19.2% at the news5; the S&P 500 Composite Index opened up 0.2%. Exhibit 1.1
illustrates the recent share-price performance for Berkshire Hathaway, PCP, and the
S&P 500 Index. Exhibit 1.2 presents recent consolidated financial statements for the
firm.
EXHIBIT 1.1 | Relative Share Price Performance of Berkshire Hathaway Class A Share, PCP, and
the S&P 500 January 1, 2015, to August 13, 2 015
Note: PCP = Precision Castparts; BRK.A = Berkshire Hathaway Class A shares; S&P500 = Standard & Poor’s 500 Index.
Data source: Google Finance.
EXHIBIT 1.2 | Berkshire Hathaway Condensed Consolidated Financial Statements
Data source: Factset.
The
acquisitio
n of PCP,
Berkshire
Hathawa
y’s
largest
deal ever,
renewed
Page 4
public
interest in
its
sponsor,
Buffett.
In many
ways, he
was an
anomaly.
One
of the richest individuals in the world (with an estimated net worth of about $66.5
billion according to Forbes), he was also respected and even beloved. Though he had
accumulated perhaps the best investment record in history (a compound annual
increase in wealth for Berkshire Hathaway of 21.6% from 1965 to 2014), 6 Berkshire
Hathaway paid him only $100,000 per year to serve as its CEO. While Buffett and
other insiders controlled 39.5% of Berkshire Hathaway, he ran the company in the
interests of all shareholders. “We will not take cash compensation, restricted stock, or
option grants that would make our results superior to [those of Berkshire’s
investors],” Buffett said. “I will keep well over 99% of my net worth in Berkshire. My
wife and I have never sold a share nor do we intend to.”7
Buffett was the subject of numerous laudatory articles and at least eight
biographies, yet he remained an intensely private individual. Although acclaimed by
many as an intellectual genius, he shunned the company of intellectuals and preferred
to affect the manner of a down-home Nebraskan (he lived in Omaha) and a toughminded investor. In contrast to the investment world’s other “stars,” Buffett
acknowledged his investment failures both quickly and publicly. Although he held an
MBA from Columbia University and credited his mentor, Benjamin Graham, with
developing the philosophy of value-based investing that had guided Buffett to his
success, he chided business schools for the irrelevance of their finance and investing
theories.
Numerous writers sought to distill the essence of Buffett’s success. What were the
key principles that guided Buffett? Could those principles be applied broadly in the
21st century, or were they unique to Buffett and his time? By understanding those
principles, analysts hoped to illuminate the acquisition of PCP. What were Buffett’s
probable motives in the acquisition? What did Buffett’s offer say about his valuation
of PCP, and how would it compare with valuations for other comparable firms?
Would Berkshire’s acquisition of PCP prove to be a success? How would Buffett
define success?
Berkshire Hathaway Inc.
Berkshire Hathaway was incorporated in 1889 as Berkshire Cotton Manufacturing
and eventually grew to become one of New England’s biggest textile producers,
accounting for 25% of U.S. cotton-textile production. In 1955, Berkshire Cotton
Manufacturing merged with Hathaway Manufacturing and began a secular decline
due to inflation, technological change, and intensifying competition from foreign
rivals. In 1965, Buffett and some partners acquired control of Berkshire Hathaway,
believing that its financial decline could be reversed.
Over the next 20 years, it became apparent that large capital investments would be
required for the company to remain competitive, and that even then the financial
returns
would be
mediocre.
Fortunate
ly, the
textile
group generated enough
cash in the early years to permit
the firm to purchase two
insurance companies
Page 5
headquartered in Omaha: National Indemnity Company and National Fire & Marine
Insurance Company. Acquisitions of other businesses followed in the 1970s and
1980s; Berkshire Hathaway exited the textile business in 1985.
The investment performance of a share in Berkshire Hathaway had astonished
most observers. As shown in Exhibit 1.3, a $100 investment in Berkshire Hathaway
stock on September 30, 1976, would compound to a value of $305,714 as of July 31,
2015, approximately 39 years later. The investment would result in a 305,614%
cumulative return, 22.8% when annualized. Over the same period, a $100 investment
in the S&P 500 would compound to a value of $1,999 for a cumulative return of
1,899.1% or 8.0% annualized.8
EXHIBIT 1.3 | Berkshire Hathaway Class A Shares versus S&P 500 Index over 39 Years
Note: Period listed as 2015 represents January 1, 2015 to July 31, 2015.
Data source: Yahoo! Finance.
In 2014, Berkshire Hathaway’s annual report described the firm as “a holding
company owning subsidiaries engaged in a number of diverse business activities.”9
Berkshire Hathaway’s portfolio of businesses included:
Insurance: Insurance and reinsurance10 of property and casualty risks worldwide
and with reinsurance of life, accident, and health risks worldwide in addition (e.g.,
GEICO, General Re).
Railroad: A long-lived asset with heavy regulation and high capital intensity, the
company operated one of the largest railroad systems in North America (i.e.,
BNSF).
Utilities and Energy: Generate, transmit, store, distribute, and supply energy through
the subsidiary Berkshire Hathaway Energy company.
Manufacturing: Numerous and diverse manufacturing businesses were grouped into
three categories: (1) industrial products, (2) building products, and (3) consumer
products (e.g., Lubrizol, PCP).
Service and Retailing: Providers of numerous services, including fractional aircraftownership programs, aviation pilot training, electronic-components distribution, and
various retailing businesses, including automotive dealerships (e.g., NetJets,
Nebraska Furniture Mart).
Finance and Financial Products: Manufactured housing and related consumer
financing; transportation equipment, manufacturing, and leasing; and furniture
leasing (e.g., Clayton Homes, ULTX, XTRA).
Exhibit 1.4 gives a summary of revenues, operating profits, capital expenditures,
depreciation, and assets for Berkshire Hathaway’s various business segments. The
company’s investment portfolio also included equity interests in numerous publicly
traded
companie
s,
summariz
ed in
Exhibit
1.5 .
Page 6
EXHIBIT 1.4 | Business-Segment Information for Berkshire Hathaway Inc. (dollars in millions)
Source: SEC documents.
EXHIBIT 1.5 | Major Investees of Berkshire Hathaway (dollars in millions)
*Actual purchase price and tax basis; GAAP “cost” differs in a few cases because of write-ups or write-downs that have
been required under GAAP rules.
**Excludes shares held by pension funds of Berkshire subsidiaries.
***Held under contract of sale for this amount.
Source: Berkshire Hathaway Inc. letter to shareholders, 2014.
Buffett’s Investment Philosophy
Warren Buffett was first exposed to formal training in investing at Columbia
University, where he studied under Benjamin Graham. A coauthor of the classic text,
Security Analysis, Graham developed a method of identifying undervalued stocks
(that is, stocks whose prices were less than their intrinsic value). This became the
cornerstone of modern value investing. Graham’s approach was to focus on the value
of assets, such as cash, net working capital, and physical assets. Eventually, Buffett
modified that approach to focus also on valuable franchises that were unrecognized by
the market.
Over the years, Buffett had expounded his philosophy of investing in his chair’s
letter to shareholders in Berkshire Hathaway’s annual report. By 2005, those lengthy
letters had acquired a broad following because of their wisdom and their humorous,
self-deprecating tone. The letters emphasized the following elements:
Economic reality, not accounting reality. Financial statements
prepared by accountants conformed to rules that might not adequately
represent the economic reality of a business. Buffett wrote:
Because of the limitations of conventional accounting, consolidated
reported earnings may reveal relatively little about our true economic
performance. Charlie [Munger, Buffett’s business partner] and I, both
as owners and managers, virtually ignore such consolidated numbers . .
. Accounting consequences do not influence our operating or capitalallocation process.11
Accounting reality was conservative, backward looking, and governed by
generally accepted accounting principles (GAAP), even though investment
decisions should be based on the economic reality of a business. In economic
reality, intangible assets such as patents, trademarks, special managerial
expertise, and reputation might be very valuable, yet, under GAAP, they
would be carried at little or no value. GAAP measured results in terms of net
profit, while in economic reality the results of a business were its flows of
cash.
A key feature of Buffett’s approach defined economic reality at the level of
the business itself, not the market, the economy, or the security—he was a
fundamental analyst of the business. His analysis sought to judge the
simplicity of the business, the consistency of its operating history, the
attractiveness of its long-term prospects, the quality of management, and the
firm’s capacity to create value.
The cost of the lost opportunity. Buffett compared an investment
opportunity against the next-best alternative, the lost opportunity. In his
business decisions, he demonstrated a tendency to frame his choices as
either/or decisions rather than yes/no decisions. Thus an important
standard of comparison in testing the attractiveness of an acquisition was
the potential rate of return from investing in the common stocks of other
companies. Buffett held that there was no fundamental difference between
buying a business outright and buying a few shares of that business in the
equity market. Thus for him, the comparison of an investment against other
returns available in the market was an important benchmark of
perfor
Page 7
mance.
Embrace the time value of money. Buffett assessed intrinsic value as
the present value of future expected performance:
[All other methods fall short in determining whether] an investor is
indeed buying something for what it is worth and is therefore truly
operating on the principle of obtaining value for his investments . . .
Irrespective of whether a business grows or dœsn’t, displays volatility or
smoothness in earnings, or carries a high price or low in relation to its
current earnings and book value, the investment shown by the
discounted-flows-of-cash calculation to be the cheapest is the one that
the investor should purchase.12
Enlarging on his discussion of intrinsic value, Buffett used an educational
example:
We define intrinsic value as the discounted value of the cash that can be
taken out of a business during its remaining life. Anyone calculating
intrinsic value necessarily comes up with a highly subjective figure that
will change both as estimates of future cash flows are revised and as
interest rates move. Despite its fuzziness, however, intrinsic value is all
important and is the only logical way to evaluate the relative
attractiveness of investments and businesses.
To see how historical input (book value) and future output (intrinsic
value) can diverge, let us look at another form of investment, a college
education. Think of the education’s cost as its “book value.” If it is to be
accurate, the cost should include the earnings that were foregone by the
student because he chose college rather than a job. For this exercise, we
will ignore the important non economic benefits of an education and
focus strictly on its economic value. First, we must estimate the
earnings that the graduate will receive over his lifetime and subtract
from that figure an estimate of what he would have earned had he
lacked his education. That gives us an excess earnings figure, which
must then be discounted, at an appropriate interest rate, back to
graduation day. The dollar result equals the intrinsic economic value of
the education. Some graduates will find that the book value of their
education exceeds its intrinsic value, which means that whœver paid for
the education didn’t get his money’s worth. In other cases, the intrinsic
value of an education will far exceed its book value, a result that proves
capital was wisely deployed. In all cases, what is clear is that book value
is meaningless as an indicator of intrinsic value.13
To illustrate the mechanics of this example, consider the hypothetical
case presented in Exhibit 1.6. Suppose an individual has the opportunity to
invest $50 million in a business—this is its cost or book value. This business
will throw off cash at the rate of 20% of its investment base each year.
Suppose that instead of receiving any dividends, the owner decides to
reinvest all cash flow back into the business—at this rate, the book value of
the business will grow at 20% per year. Suppose that the investor plans to
sell the business for its book value at the end of the fifth year. Dœs this
investment create value for the individual? One determines this by
discounting the future cash flows to the present at a cost of equity of 15%.
Suppose that this is the investor’s opportunity cost, the required return that
could have been earned elsewhere at comparable risk. Dividing the present
value of future cash flows (i.e., Buffett’s intrinsic value) by the cost of the
invest
Page 8
ment
(i.e.,
Buffett’
s book
value)
indicat
es that
every
dollar
investe
d buys
securiti
es
worth
$1.23.
Value
is
created
.
EXHIBIT 1.6 | Hypothetical Example of Value Creation
Source: Author analysis.
Consider an opposing case, summarized in Exhibit 1.7. The example is
similar in all respects, except for one key difference: the annual return on the
investment is 10%. The result is that every dollar invested buys securities
worth $0.80. Value is destroyed.
EXHIBIT 1.7 | Hypothetical Example of Value Destruction
Source: Author analysis.
Comparing the two cases in Exhibits 1.6 and 1.7, the difference in value
creation and destruction is driven entirely by the relationship between the
expected returns and the discount rate: in the first case, the spread is
positive; in the second case, it is negative. Only in the instance where
expected returns equal the discount rate will book value equal intrinsic
value. In short, book value or the investment outlay may not reflect the
economic reality. One needs to focus on the prospective rates of return, and
how they compare to the required rate of return.
Measure performance by gain in intrinsic value, not accounting
profit. Buffett wrote:
Our long-term economic goal . . . is to maximize Berkshire’s average
annual rate of gain in intrinsic business value on a per-share basis. We
do not measure the economic significance or performance of Berkshire
by its size; we measure by per-share progress. We are certain that the
rate of per-share progress will diminish in the future—a greatly
enlarged capital base will see to that. But we will be disappointed if our
rate dœs not exceed that of the average large American corporation.14
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.
The gain in intrinsic value was analogous to the economic-profit and marketvalue-added measures used by analysts in leading corporations to assess
financial performance. Those measures focus on the ability to earn returns in
excess of the cost of capital.
Set a required return consistent with the risk you bear.
Conventional academic and practitioner thinking held that the more risk one
took, the more one should get paid. Thus discount rates used in determining
intrinsic values should be determined by the risk of the cash flows being
valued. The conventional model for estimating the cost of equity capital was
the capital asset pricing model (CAPM), which added a risk premium to the
long-term risk-free rate of return, such as the U.S. Treasury bond yield. In
August 2015, a weighted average of Berkshire Hathaway’s cost of equity and
debt capital was about 0.8%.15
Buffett departed from conventional thinking by using the rate of return
on the long-term (e.g., 30-year) U.S. Treasury bond to discount cash flows—
in August 2015, the yield on the 30-year U.S. Treasury bond was 2.89%.
Defending this practice, Buffett argued that he avoided risk, and therefore
should
Page 9
use a
riskfree
discou
nt rate.
His
firm
used
little
debt
financi
ng. He
focused
on
compa
nies
with
predict
able
and
stable
earnings. He or his vice chair, Charlie Munger, sat on the boards of directors,
where they obtained a candid inside view of the company and could
intervene in management decisions if necessary. Buffett once said, “I put a
heavy weight on certainty. If you do that, the whole idea of a risk factor
dœsn’t make sense to me. Risk comes from not knowing what you’re doing.”1
6 He also wrote:
We define risk, using dictionary terms, as “the possibility of loss or
injury.” Academics, however, like to define “risk” differently, averring
that it is the relative volatility of a stock or a portfolio of stocks—that is,
the volatility as compared to that of a large universe of stocks.
Employing databases and statistical skills, these academics compute
with precision the “beta” of a stock—its relative volatility in the past—
and then build arcane investment and capital allocation theories around
this calculation. In their hunger for a single statistic to measure risk,
however, they forget a fundamental principle: it is better to be
approximately right than precisely wrong.17
Diversify reasonably. Berkshire Hathaway represented a diverse portfolio
of business interests. But Buffett disagreed with conventional wisdom that
investors should hold a broad portfolio of stocks in order to shed companyspecific risk. In his view, investors typically purchased far too many stocks
rather than waiting for one exceptional company. Buffett said:
Figure businesses out that you understand and concentrate.
Diversification is protection against ignorance, but if you don’t feel
ignorant, the need for it gœs down drastically.18
Invest based on information, analysis, and self-discipline, not on
emotion or hunch. Buffett repeatedly emphasized awareness and
information as the foundation for investing. He said, “Anyone not aware of
the fool in the market probably is the fool in the market.” 19 Buffett was fond
of repeating a parable told to him by Graham:
There was a small private business and one of the owners was a man
named Market. Every day, Mr. Market had a new opinion of what the
business was worth, and at that price stood ready to buy your interest or
sell you his. As e …
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