Warren Buffett's Perspective What Is the Intrinsic Case Study

Excerpt from Case Study :

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.…

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