Warren Buffett\'s Perspective, What Is the Intrinsic

¶ … Warren Buffett's 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?

Intrinsic value is concisely summed up by Warren Buffett as "the present value of future expected performance" (Bruner, Eades, & Schill, 2009). This intrinsic value can summarize how well a company is run, its cash flow and places a premium on management competency. Intrinsic value is thought to be important in value investing as it allows Buffett to identify stocks or businesses which are undervalued. This is important because value investors use a variety of analytical techniques in order to estimate the intrinsic value of securities in hopes of finding investments where the true value of the investment exceeds its current market value (Intrinsic Value, 2012).

Buffett readily admits that intrinsic value is highly subjective (Bruner et al., 2009). Buffett's method is to estimate discounted cash flows. This is a valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them, most often using the weighted average cost of capital, to arrive at a present value, which is used to evaluate the potential for investment (Discounted Cash Flow -- DCF, 2012).

An alternative to intrinsic value is book value or accounting profit. This is a company's total earnings, calculated according to Generally Accepted Accounting Principles (GAAP), and includes the explicit costs of doing business, such as depreciation, interest and taxes (Accounting Profit, 2012). That is instead of investing based on the company book value or accounting statements instead.

Buffett rejects these alternatives as he emphasizes "economic reality, not accounting reality" (Bruner et al., 2009). Book value is useless as a determinant of intrinsic value as it does not fully reflect the relationship between rates of return and the required rate of return. Typically book value is thought to be historical input whereas intrinsic value is the measure of future output (Bruner et al., 2009).

(b) Critically assess Buffett's investment philosophy. Identify points where you agree and disagree with him.

Value investors look for securities with prices that are unjustifiably low based on their intrinsic worth. When talking about stocks, determining intrinsic value can be a bit complicated as there is no commonly accepted way to obtain this figure. Most frequently intrinsic worth is estimated by analyzing a company's fundamentals. Value investors seek products that are beneficial and of high quality but underpriced. In other words, the value investor searches for stocks that he or she believes are undervalued by the market.

Warren Buffett takes this value investing approach to another level. Many value investors aren't supporters of the efficient market hypothesis, but they do trust that the market will eventually start to favor those quality stocks that were, for a time, undervalued. He isn't concerned with the supply and demand intricacies of the stock market. In fact, he's not really concerned with the activities of the stock market at all. He chooses stocks solely on the basis of their overall potential as a company. Holding these stocks as a long-term play, Buffett seeks not capital gain but ownership in quality companies extremely capable of generating earnings.

(c) Should Berkshire Hathaway's shareholders endorse the acquisition of PacifiCorp? Why?

The Berkshire Hathaway shareholders should endorse the acquisition of PacifiCorp. It took a while for Mr. Buffet to finally invest their cash equivalents because he was looking for a company that makes significant gains. Factors that make it a good acquisition include the fact that PacifiCorp is a low-cost energy producer but has the biggest market share among the energy companies which is almost two million customers divided among six states plus the intrinsic value of the company is much higher than the market value of PacifiCorp.

Case 2

a) How well has Value Trust performed in recent years? In making that assessment, what benchmark(s) are you using? How do you measure investment performance? What does good performance mean to you?

Over recent years Value Trust has done very well. By the middle of 2005, Value Trust had outperformed its benchmark index, the S&P 500, for an unprecedented 14 years in a row (Brunner, et al., 2009). This marked the longest streak of success for any manager in the mutual fund industry. Investment performance can be measured by comparing returns with a benchmark. The idea is to beat the benchmark. If one can not beat the benchmark then it is better to buy it. This will save money and time in the long run (Traganidas, 2010). If a stock or fund consistently shows good performance over a ten to twelve year period then to me it is a good investment and one that should be strongly considered.

(b) What might explain the fund's performance? To what extent do you believe an investment strategy, such as Miller's, explains performance?

When using a valuation approach in order for investors to choose a company that will be worthy of the investment, investors often use a payback period. The payback period is the number of years needed to return the original investment from the net cash flows (net operating income after taxes plus depreciation). If the investor has the policy of employing payback period, which means that, which ever Value Trust has the minimum years of having the investment or the cost of capital back, that Value Trust will be accepted for investments. The advantages of the payback period are that, it is easy to calculate, however wrong calculations may lead to wrong decisions. The output of this approach will determine the number of years the capital investment will be returned that will be the basis of the investor's decisions. Another advantage of this approach is, it put more emphasis to quick return of the invested fund so that this fund may be used again in other places or for meeting other needs; moreover this approach is easy to apply and simple to understand.

However, the approach does not consider post-payback cash flows and does not include the time value of money which is also essential in decision making. Moreover, another disadvantage of this approach is, it does not explicitly consider risk and the suitable time period is just arbitrary. Without these things, the investor might make wrong decision that may pull their business or stocks back from scratches.

(c) Consider the mutual fund industry. What roles do portfolio managers play? What are the differences between fundamental and technical securities analysis? How well do mutual funds generally perform relative to the overall market?