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EXECUTIVE SUMMARY

This case study is aiming at giving a close insight at the steps


Warren Buffet completed to acquire a utility-based company,
PacifiCorp, in an effort to diversify the activities of Berkshire
Hathaway.
The case study exposes the basics of enterprise valuation
using two different methods: multiple valuations and discount factor.
It also brings a reflection on how to establish reliable and suitable
valuations to best evaluate a potential acquisition deal. It also
shows how to evaluate the impact such a single-investment can
have on the acquiring company and the potential remarks on the
investment decisions associated with such an acquisition. The core
of the case study is held through the assessment of every
participant, from the market investors, to the seller and the acquirer.
Assessing the bid of Berkshire Hathaway for the acquisition of
PacifiCorp questions the choice of valuation techniques and
ultimately assesses Warren Buffett move in the utility industry. The
deal appraisal brought to consider a broader picture on the
evaluation of previous Berkshire Hathaways acquisitions and how
they evolved in comparison to the main stock index and other large
companies.
Finally the case study let ponder on Warren Buffett investment
philosophy to effectively find consistency or incongruity in his belief.
1.

Market reaction
a. On the day MidAmerican Energy Holdings announced its
acquisition of PacifiCorp from Scottish Power plc, the market reacted
in the following way:
- Berkshire Hathaways A share price increased by 2.4%
- Scottish Powers share price rose by 6.28%
- S&P 500 Composite Index value accrued by 0.02%
According to the above numbers, it would be correct to say the
stock market has been positively reacting to the acquisition. It could
be interpreted as a good indicator that the deal has been worthwhile
for both the acquirer and the seller. The positive reaction from stock
market also reveals that the deal has created value for both
protagonists.
b. According to the increasing per-share changes in both
companies, it would be correct to assume that value has been
created from this deal. By closing up by 2.4%, Berkshire Hathaway
increased its market value by $2.55 billion. This instant increase in
share price could be interpreted as an expected benefit from this
acquisition, and ultimately, could reveal that Berkshire Hathaway
paid the acquisition at a discount price per share.
Similarly, Scottish Powers increase by 6.28% represents an
increase of GBP27.75 in per-share change. Because the amount of
share outstanding for Scottish Power is 466,120,000, the increase in
market value that day was $12.93 billion British pounds.

Warren E Buffett Group 1


c. As mentioned above, the $2.55 billion increase in market
value could be interpreted as the expected benefit from the
acquisition. Proposing $5.1 billion in cash for the equity of PacifiCorp
could be translated in buying the amount of shares outstanding
from PacifiCorp (312,180,000) at $16.83 per share.
5,100,000,000
=$ 16.83/ share
312,180,000
Bringing the gain in market value to a per-share basis, it would
represent the gain in per-share price Berkshire Hathaway underwent
in the acquisition process and therefore its benefit.
2,550,000,000
=$ 8.17 / Share
312,180,000
On a per-share basis, the expected benefit of $2.55 billion is $8.17
per share.
2.

Choice of valuation methods

The PacifiCorp is worth $9.023 billion on its own before the


acquisition.
This value was taken from the median Enterprise Value as
multiple of EBITDA from exhibit 10. The calculation method of this
value is shown on the appendix. The firm value of PacifiCorp was
calculated using the EBITDA multiple. The EBITDA multiple is
commonly used to compare firms in the same industry that has a
comparable level of capital intensity, as the EBITDA is used as a
proxy for operating cash flow available to the firm. EBITDA multiple
is unaffected by differences in depreciation policy, capital structure
and tax management. However, the EV/ EBIT would be affected by
the differences in depreciation policy. The EV/revenue ratio only
focus on the companys sales, and the EV/ Net income ratio would
be affected by different capital structures and tax rates.
The valuation multiple method is a better approach to value the
PacifiCorp rather than using the discount cash flow method. The
reason is because the PacifiCorp is a private owned company, its
cash flow statement are not publicly available, and thus, the
discount cash flow method is not a good way to measure the value
of the company. It is easier to use the multiple model in this case as
there are statistics information available for similar comparable
companies in the same industry. The valuation of PacifiCorp was
using the Enterprise Value, the reason is because Berkshire
Hathaway acquired the entire company of PacifiCorp, and using
enterprise value multiples can minimize the differences of
accounting policy, which gives a more accurate value for PacifiCorp
being acquired. On the other hand, there are disadvantages of using
valuation multiples, as it would be difficult to value the firm when
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Warren E Buffett Group 1


the comparable firms in the same industry are mispriced. Moreover,
multiples measure value at a single point in time and do not fully
capture the dynamic of business and competition.
A valuation multiple is the ratio of firm value or equity value to
the firms economic activity such as sales, EBIT or EBITDA. The
valuation steps are shown in the appendix. The multiples
calculation is based on the figures for each comparable company
given in Exhibit 7, 9 and 10. Firstly, calculate the multiple of the
comparable firms economic activity, and then calculate their
median and mean. Next, find the value of PacifiCorp in each of the
economic activity. Finally, using the value of PacifiCorp found in the
previous step multiply by the median and mean of multiples in each
economic activity gives the implied value of PacifiCorp.

Warren E Buffett Group 1


3.

Bid assessment

a. The acquisition of PacifiCorp by Berkshire Hathaway has cost


$5.1 billion in cash and $4.3 billion in liabilities and preferred stocks
totalling a cost of $9.4 billion dollars. The estimations from the
previous question should support the assessment to determine if
Warren Buffetts bid price was in accordance to his investment
philosophy, acquiring the company for a price below or equal the
intrinsic value of PacifiCorp.
b. While trying to compare the bid value with the intrinsic value
of the company, it is important to bear in mind that Warren Buffet
defines the intrinsic value of a company as being the discounted
value of future cash flow back to the present.
As matter of fact, using net income as a component for
enterprise valuation would not be as efficient as other component
such as EBITDA or EBIT as net income is mainly representing the
accounting profit rather than the actual cash flow. A multiple of
revenue for enterprise valuation is measuring the final total cash
inflow generated by a firm. As a matter of fact, it could be used a
good measure of cash flow but still not the best representation as it
might not represent the real picture of the company.
Using more than one multiple to valuate a company is a good
initiative as it gives an overall picture of the enterprise value. Even
though, they do not give an exact valuation they propose a large
range of valuation regarding all aspect of the company at different
stages of its earning processes (before expenses, before
depreciation, before tax, after tax). Nonetheless one should focus
on EBITDA and secondly EBIT multiple to confirm their bid valuation
as there have been confirmed as being the most suitable multiple
for precisely valuate a firm.
c. Using exhibit 10, the enterprise valuation as multiple of all
components is ranging from $6.252 billion and $9.289 billion and
the market value equity as multiple range from $4.277 billion to
$5.904 billion.
Considering Warren Buffett bid of $5.1 billion in cash for the
equity of PacifiCorp and comparing the bid with the market value
equity as multiple of EPS, Buffett could have overpriced his bid (+
$923 million using median, +$796 million using mean). However,
considering the $5.1 billion cash bid and the market value equity as
multiple of book value, we can consider that the bid is undervalued
compared to both the median ($5.904 billion) and the mean
($5.678 billion). Taking into consideration the market value of
equity seen above, Warren Buffett could tend to misjudge the
profits the company shares will generate in the future but it is
important to specify that because the federal and state regulatory
reviews would take 12 to 18 months to be completed, applying a
discount factor on the payment over that period would eventually
bring the bid closer to the actual value of the company.
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Warren E Buffett Group 1

4.

Past performance: How well Berkshire Hathaway has


performed during 1965-2004?
Maybe considered as the best investment record in history,
Warren Buffet has aggregated a compounded annual increase in
wealth for Berkshire Hathaway of 24% from 1965 to 2004. According
to Berkshire Hathaways 2004 annual report, the company has
performed on an average 11.5% better than the S&P 500 Composite
Index over the same period. Also, the annual average total return on
all large stocks from 1965 to the end of 2004 was 10.5%, which
represents a difference of 13.5% difference with Berkshire Hathaway
over the 40-year-period. In a simpler form, Berkshire Hathaway has
been the best performing company on average over the last 40
years period.
Berkshire Hathaway has experienced returns as high as 59.3%
(1976) and only experienced negative return once during that
period (-6.2% in 2001).
However, it is important to note that S&P500 numbers are pretax while Berkshire Hathaway returns numbers shown are after-tax
(BH Annual report 2004). This precision is important as if numbers
were to be adjusted on the same basis, the difference between
Berkshire Hathaway performance and the S&P500 Composite Index
would be greater.
In the 2004 annual report for Berkshire Hathaway, Warren Buffett
explicitly stipulated that such high returns on such a long period of
time must not be taken as an indicator of future performance. Even
though Buffett hopes that the company rate of return will exceed
the average rate of return of large American corporation, he expects
the company per-share to diminish as the capital base greatly
expanded.
5. Investment value
The NPV (net present value) method is utilised commonly to access an investment
valuation. The net present method is basically using the present value of the cash
inflows compare to the initial cash outflows to obtain the net gain of an investment. In
the case, the present value of the cash inflows for the investment of Berkshire would
be the present value of the free cash flow of MidAmerican energy Holdings in 2000
and takes account of the economic interests. And the cash outflow for Berkshire
would be the present value of the initial cost for the acquisition in 2000. The NPV is
t
CF t
TV
+
) IV.
formulated at NPV= (
t
( 1+r )t
t=1 ( 1+ r )
The case should contain assumptions for the effectiveness of the valuation process.
Firstly, all cash flows should follow reinvestment assumptions and could be
reinvested at the discount rate. (Ahn,T. 2014). Secondly, it is assumed that PP&E
acquisition is base on cash payment. Thirdly, all the current assets and liabilities in the
balance sheet have been pooling into other assets and other liabilities for simplicity
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Warren E Buffett Group 1


purpose. Normally, other assets will include inventories, accrued income, tax assets,
other liquidity assets and miscellaneous assets, and other liabilities will include
account payable, short-term debt, accrued expenses etc. (FDIC, 2014). However
some of them are exempted in cash flow process, like debts, financial assets and cash
item. The case should be assumed that there are no exclusive items included. There
were no detail information about minority interest and as it is exemption. The
minority interest should be regarded as zero. Further, in order to build the discount
model, it should assume that the firm pay dividend based on the FCF and will with
perpetuity constant growth since 2004.
The investment valuation will be based on two sections: the present value of the four
year FCF and the terminal value of MidAmerican with 80.5% economic interest in
2000, and compare the present values with the initial investment cost. The very first is
to work out the free cash flow of MidAmerican based on exhibit 6. The FCF is
operating CF- net capital spending- change in net working capital (Anh,T. 2014).
The graph shows the FCF result of MidAmerican from 2001 to 2004, and the accruing
FCF to Berkshire is based on the economic interest.
2001
$m
FCF of MidAmerican Energy
Holding
Economic interest for Berkshire
FCF accruing to Berkshire

2002
$m

253.2 -3064.4

2003
$m

2004
$m

1290.2

1326.4

76% 83.70% 80.50% 80.50%


192.4 -2564.9 1038.6 1067.8

Step 1:
Firstly, apply dividend discount model to access the present value of the four year
accruing cash flows. As the MidAmerican will has a constant growth rate perpetuity
t
CF t
start from 2004. It would be assessed by discount model: PV=
. Based
t
t =1 ( 1+ r )
on the accruing FCF and the CAPM rate 9%, the PV of the four years FCF is sum up
to $-423.9m. Secondly, taking account of the constant growth rate from 2004, apply
CF 2004 (1+ g)
the formula TV = (rg) ' to work out the terminal value in 2004 and then
discount it back to 2000, which equals to $11022.2m. The aggregated present value of
the investment is $10598.3m.
Step 2:
Compare the value of the investment with initial investment cost of Berkshire
Hathaway in 2000. Remember to aggregate the present value of investment cost of
$402m with the cost of $1240m to figure out the total cost of the investment
$1578.4m in 2000. By doing this, the NPV is resulted at $9019.9m with an initial rate
of return 67%.
Based on the quantitative analysis above, although MidAmerican generated some
negative cash flow in some year due to business expansion, it still create value for
5

Warren E Buffett Group 1


Berkshire Hathaway to invest in MidAmerican as the firm will continuing grow in the
future. And the value created worth far more than the cost of the investment.
6.
Investment assessment
In the year between 1988 and 2003, Berkshire invested total up to $3832m in the Big
Four( American Express Company, The Coca-Cola Company, The Gillette company
and Wells Fargo& Company) which market value worth $24681m at the end of 2004.
The weighted purchase date was 1992 and the weighted basis time period is 12.5
years in total. There will be two methods used to assess the investment in Big Four.
First one is the compound annual growth rate (CAGR) which is formula in
Ending value 1n '
'
1 . Within the formula, the ending value of the investment
Beginning value

is the market value of the Big four in 2004 and the beginning value is the investment
cost in 1992. By input the values and 12.5 years, and the CAGR for the 12.5 years
investment would be 16.07%. It represents a smoothed annualized investment gain of
16.07% for Berkshire over the 12.5 years period.
Another method would be using NPV method to work out the net gain of the
investment by comparing the present market value of the Big Four in 1992 with the
total investment cost in Big Four within the same period. Firstly, simply discount the
market value of Big Four in 2004 back to 1992 with 9% discount rate. Because the
investment is made by Berkshire, the discount rate used to evaluate the market value
of the Big Four should be the cost of equity of Berkshire. The discounted market
value of Big Four is up to $8405m in 1992. Comparing $8405m market value with
$3832m initial investment in 1992, the difference $4573m would be the net gain for
Berkshire. According the NPV rules, positive $4573m is an optimistic desirable gain.
Also the market value to cost ratio in 2000 is $2.19. It reveals that every $1 Berkshire
Hathaway invests in the Big Four, can earn $2.19 in return. It is a good investment
for Berkshire to generate over twice in return. Further, since 1992, the Big Four
shows a positive increasing pattern in the stock market which market price of the
shares increasing significant amounts.

7.

Investment philosophy
Warren Buffetts investment philosophy is derived from Prof. Benjamin Graham
method of identifying undervalued stocks, which he supplemented the notion of
recognising undervalued franchise from the market. He abides by 7 principles that he
defines as being essential in performing an efficient investment. Buffetts principles
are actually simple, easy to be understood and followed. In common, his
character is conventional as he sees prospects of an investment in
the long-term prospective and his success is a combination of
careful calculation, courage and patience. The following section
assesses Buffetts investment philosophy:.
1. Economic reality, not accounting reality
According to Buffett, accounting principles are backwardlooking and abide by generally accepted accounting principles
(GAAP). As a matter of fact, he distinguishes economic reality and
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Warren E Buffett Group 1


accounting reality as accounting principles might not recognised
intangible assets as a valuable carriers. He also acknowledges that
accounting principles does not focus on flows of cash, as he thinks
economic reality does. It is important to note that Buffett
exaggerates his disinterest in accounting numbers as he says,
Accounting consequences do not influence our operating or capitalallocation process. It is a quiet strong statement considering his
desire for consistent returns and little debt as this could hardly be
realized without looking at financial statements. However, the
confident tone used by Buffett in the annual report may be
perceived as a strategic tool to emphasise his point to the
shareholders.

2. The cost of lost opportunity


In his investment decision-making process, Buffett always
compares his choice with another opportunity. Actually, it is nothing
unusual in comparing one choice against another. Buffett considers
the cost of losing the other opportunity. In this case, Buffett sees the
true cost of an investment being what you give up (the other
opportunity) to get it. This not only includes the money spent in
buying that asset but also the economic benefits or once you bought
that particular asset you no longer buy something else with that
money.
3. Value creation: time is money
Warren Buffett defined intrinsic value as being 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
expected net cash flows 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 be taken as the measure of the interest rate
for this calculation. The discounted cash-flow approach is very
conservative as long as an appropriate discount rate is applied. In
spite of its uncertainty, intrinsic value is important because it cannot
be denied that book value is actually meaningless in relation to the
future potential growth. Therefore, the lesson that can be obtained
from this third philosophy is that one should really pay attention to
the business future potential growth, not the amount of investment
that is 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 per7

Warren E Buffett Group 1


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, the gain in intrinsic value is referred to be similar to
the Economic Value Added (EVA) or Market Value Added measures.
These measurements focus on the ability to earn returns in excess
of the cost of capital. The difference between a company's return
and its cost of raising capital is called the 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 performance is measured by a gain in intrinsic
value, it is 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, it is
believed 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 and discount rates
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 riskfree discount rate such as the rate of return on the long-term U.S.
Treasury bond. Here, one would disagree with Buffett. In the world of
finance, risk and return is one of the basic principles, where it is
related to one another as 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 fortune-teller. Therefore it is not prudent to discount all future cash
flows at the risk free rate and one 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 is sometimes misunderstood, that
Buffet is against diversification. The main idea of this philosophy is
that investors should understand a companys operating
fundamentals, where they need to adopt the concept of intelligent
investing. Investors should act like the owner of the business, not
the owner of a piece of paper. In this case, very few business owners
8

Warren E Buffett Group 1


are comfortable and have the ability to operate a number of
companies at the same time, therefore, Buffett believed that it is
not necessary to diversify if the objectives is only for spreading
away investment risks.
However the breadth of Berkshire Hathaways holdings
probably approaches efficient diversification. Exhibit 2 gives a
breakdown of Berkshires diverse business segments, which are also
described in the case; Exhibit 3 gives a listing of Berkshires 10
major investees. Thereby, despite his public disagreement with the
concept of diversification, Buffett seems to practice it.
In conclusion, diversification will be much better if it is
accompanied with deep understanding on the business itself.
7. Investors behaviour should be driven by information and selfdiscipline, 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 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. From this part of Buffetts philosophy, it
is essential to use intellect not emotion when investing.
The lessons that can be extracted from this philosophy is:

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

Warren E Buffett Group 1

Reference list
Anh,T (2014), Lecture note stock valuation. [Online]. Available at:
http://moodle.city.ac.uk/mod/resource/view.php?id=258565 .
Anh, T (2014). Lecture note Investment decision rules. [Online]. Available at:
http://moodle.city.ac.uk/mod/resource/view.php?id=258582 .
FSIC (Federal Deposit Insurance Corporation)(2014). RMS Manual of Examination
polices Other assets and liability (3/12) section 3.7. [Online]. Available at:
https://www.fdic.gov/regulations/safety/manual/section3-7.pdf.

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Warren E Buffett Group 1


APPENDIX

Visual Assessment of PacifiCorp's bid


10,000
9,000
8,000

Median

7,000

Mean

6,000

Bid

5,000
4,000
3,000
2,000
1,000
0

Visual Assessment of PacifiCorp's Equity bid


7,000
6,000
5,000
4,000

#REF!

#REF!

#REF!

3,000
2,000
1,000
0

11

Warren E Buffett Group 1

Question 5
(All in million $)
EBT
Other interest expense
Interest expense
debt held by Berkshire
EBIT
Tax (40%)
EBI
Depreciation

2000

Operating cash flow


PPE
Net capital spending
Current assets
Current liabilities
Net working capital
Change in net working capital
FCF of MidAmerican Energy
Holding

5349
2659
3154
-495

Economic interest for Berkshire


FCF accruing to Berkshire
Discount rate
Constant growth rate starting 2004

2001
419
443

2002
523
640

2003
727
716

2004
816
713

50

118

184

170

912
364.8
547.2
539
1086.
2
6537
1188
2450
3300
-850
-355

1281
512.4
768.6
530

1627
650.8
976.2
603

1699
679.6
1019.4
638

1298.6

1579.2

1657.4

10285
3748
3892
4127
-235
615
3064.4
83.70
%
2564.9

11181
896
3658
4500
-842
-607

11607
426
3990
4927
-937
-95

1290.2

1326.4

80.50
%

80.50
%

1038.6

1067.8

2003

2004

1038.6

1067.8

802.0

756.4

253.2
76%
192.4
9%
2%

Step 1

2001

FCF accruing to Berkshire

192.4

Discounted CF

176.5

PV of first 4 years CF

-423.9

FCF( with constant g=2%) in 2005


FCF in 2005 accruing to Berkshire (80.5%)
Terminal value accruing to Berkshire in
2004

1352.9
1089.1
15558.
7
11022.
2

PV in 2000

Total PV of FFCF

2002
2564.9
2158.8

10598.
3
12

Warren E Buffett Group 1


Step 2
Initial investment
total PV of Initial investment

2000
1240
1578.4
10598.
3
9019.9
67%

Total PV of FFCF
NPV
IRR

2002
402

IRR calculation
cash flow
2000
-1578.4
2001
192.4
2002
-2564.9
2003
1038.6
2004
16626.4
IRR
67%

Question 6
company (Big
Four)
American
Express
Coca-Cola
Gillette
Wells Fargo

shares

%of CO.
owned

151,610,7
00
200,000,0
00
96,000,00
0
56,448,38
0

Cost
($mm)

12.1

1470

8546

17%

8.3

1299

8328

16%

9.7

600

4299

14%

3.3

463

3508

13%

3832

24681

Total for the


portfolio
Years
Discount rate
Market value of the "Big four" portfolio
Total cost for the "Big Four" portfolio
Method 1(CAGR)
Compound annual growth rate
(Ending value/ beginning value)^(1/n) -1
Method 2(NPV)
Discounted the market value in 2004 to
1992
Discount rate

Market($m Cost/
m)
Market

12.5
9%
$24681mm
$3832mm

16.07%

9%
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Warren E Buffett Group 1


Market value
Years
PV of the Market value of the Portfolio
NPV
PV of market value/ cost

$24681mm
12.5
$8405mm
$4573mm
$2.19

14