Warren Buffett Case Analysis

I did analysis but my professor say I did wrong calculate. Please help me find out what I did wrong in calculate with formula. Also he say I need to explain specific and follow article information. Please read article “Warren E Buffett, 1995” in “UV006” pdf file and follow instruction in “Case Warren Buffett Analysis Instruction” file below that I give it to you. Answer carefully all questions in the Instruction file and calculate with formula for answer question. Explain specific answer with follow information in article. Do on Microsoft Word. I will give you my analysis paper to fix it.Please DO NOT COPY IDEA ON INTERNET. Espectually on www.coursehero.comMy professor will turn this paper into turnitin.com website
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UV0006
Rev. Jul. 1, 2015
Warren E. Buffett, 1995
On August 25, 1995, Warren Buffett, the CEO of Berkshire Hathaway, announced that his firm would
acquire the 49.6% of GEICO Corporation that it did not already own. The $2.3 billion deal would give GEICO
shareholders $70 per share, up from the $55.75 per share market price before the announcement. Observers
were astonished at the 26% premium that Berkshire Hathaway would pay, particularly as Buffett proposed to
change nothing about GEICO, and there were no apparent synergies in the combination of the two firms. At
the announcement, Berkshire Hathaway’s shares closed up 2.4% for the day, for a gain in market value of $718
million.1 That same day, the S&P 500 Index closed up 0.5%.
The acquisition of GEICO renewed public interest in its architect, Warren E. Buffett. In many ways, he
was an anomaly. One of the richest individuals in the world with an estimated net worth of about $7 billion, he
was also respected and even beloved. Although he had accumulated perhaps the best investment record in
history (a compound annual increase in wealth of 28% from 1965 to 1994),2 Berkshire Hathaway paid him only
$100,000 per year to serve as its CEO. Buffett and other insiders controlled 47.9% of the company, yet he ran
the company in the interests of all shareholders. He was the subject of numerous laudatory articles and three
biographies,3 but he remained an intensely private individual. Though 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 tough-minded investor. In contrast to investing’s other “stars,” Buffett
acknowledged his investment failures both quickly and publicly. He held an MBA from Columbia University
and credited his mentor and professor, Benjamin Graham, with developing the philosophy of value-based
investing that guided him to his success. Buffett 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
him? Could those principals be applied broadly in the late 1990s and into the 21st century, or were they unique
to Buffett and his time? From an understanding of those principles, analysts hoped to illuminate Berkshire
Hathaway’s acquisition of GEICO. Under what assumptions would the acquisition make sense? What were
Buffett’s probable motives in the acquisition? Would the acquisition of GEICO prove to be a success? How
would it compare to the firm’s other recent investments in Salomon Brothers, USAir, and Champion
International?
The change in Berkshire Hathaway’s share price at the date of the announcement was $609.60. The company had outstanding 1,177,750 shares.
Buffett’s initial cost per share in Berkshire Hathaway in 1965 was about $17.578. On August 25, 1995, the price per share closed at $25,400.
3 Robert G. Hagstrom Jr., The Warren Buffett Way (New York, NY: John Wiley & Sons, 1994); Andrew Kilpatrick, Of Permanent Value: The Story of
Warren Buffett (Birmingham, AL: AKPE, 1994); Roger Lowenstein, Buffett: The Making of an American Capitalist (New York, NY: Random House, 1995).
1
2
This case was prepared by Professor Robert F. Bruner as a basis for class discussion rather than to illustrate effective or ineffective handling of an
administrative situation. Copyright © 1996 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order
copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or
transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.
This document is authorized for use only by Ivan Ljubicic (Ivanljubicic111@gmail.com). Copying or posting is an infringement of copyright. Please contact
customerservice@harvardbusiness.org or 800-988-0886 for additional copies.
Page 2
UV0006
Berkshire Hathaway, Inc.
The company 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 the country’s cotton textile production.
In 1955, Berkshire merged with Hathaway Manufacturing and began a secular decline due to inflation,
technological change, and intensifying competition from foreign competitors. In 1965, Buffett and some
partners acquired control of Berkshire Hathaway, believing that the decline could be reversed. Over the next
20 years, it became apparent that large capital investments would be required to remain competitive and that
even then the financial returns would be mediocre. In 1985, Berkshire Hathaway left the textile business.
Fortunately, the textile group generated enough cash in the initial years to permit the firm to purchase two
insurance companies headquartered in Omaha: National Indemnity Company and National Fire & Marine
Insurance Company. Acquisitions of other businesses followed throughout the 1970s and 1980s.
The investment performance of a
share
in
Berkshire
Hathaway
astonished most observers. In 1977,
the firm’s year-end closing share price
was $89.00. On August 25, 1995, the
firm’s closing share price was
$25,400.00. In comparison, the annual
average total return on all large stocks
from 1977 to the end of 1994 was
14.3%.4 Over the same period, the S&P
500 Index grew from 107 to 560. Some
observers called for Buffett to split the
firm’s share price, to make it more
accessible to the individual investor.
Buffet steadfastly refused.
Share Price of Berkshire Hathaway versus S&P 500
Index
$100,000
$10,000
$1,000
$100
BH
S&P500
$10
$1
In 1994, Berkshire Hathaway
described itself as “a holding company owning subsidiaries engaged in a number of diverse business activities.”5
Exhibit 1 gives a summary of revenues, operating profits, capital expenditures, depreciation, and assets for the
various segments. By 1994, Berkshire’s portfolio of businesses included:
?
Insurance Group. The largest component of Berkshire’s portfolio focused on property and casualty
insurance, on both a direct and reinsurance basis. The investment portfolios of the Insurance Group
included meaningful equity interests in 10 other publicly traded companies. The equity interests are
summarized in Exhibit 2, along with Berkshire’s share of undistributed operating earnings in those
companies. Because the earnings in some of those companies could not be consolidated with
Berkshire’s because of the U.S.’s generally accepted accounting principles (GAAP), Buffett published
Berkshire’s “look-through” earnings6—as shown in Exhibit 2, the share of undistributed earnings of
major investees accounted for 40%–50% of Berkshire’s total look-through earnings. Exhibit 3
Stocks, Bonds, Bills, and Inflation (Chicago: Ibbotson Associates, 1994), 10.
Berkshire Hathaway, Inc., annual report, 1994.
6 Look-through earnings were calculated as the sum of Berkshire’s operating earnings reported in its income statement, plus the retained operating
earnings of major investees not reflected in Berkshire’s profits, less tax on what would be paid by Berkshire if those earnings had been distributed to
Berkshire. The presentation used a 14% tax rate, the rate Berkshire paid on the dividends it received.
4
5
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summarizes investments in convertible preferred stocks7 that Berkshire Hathaway had made in
previous years, serving as a white squire to major corporations—each of those firms had been the
target of actual or rumored takeover attempts.
?
Buffalo News. A daily and Sunday newspaper in upstate New York.
?
Fechheimer. A manufacturer and distributor of uniforms.
?
Kirby. A manufacturer and marketer of home cleaning systems and accessories.
?
Nebraska Furniture. A retailer of home furnishings.
?
See’s Candies. A manufacturer and distributor of boxed chocolates and other confectionary products.
?
Childcraft and World Book. A publisher and distributor of encyclopedias and related educational and
instructional material.
?
Campbell Hausfeld. A manufacturer and distributor of air compressors, air tools, and painting systems.
?
H.H. Brown Shoe Company; Lowell Shoe, Inc., and Dexter Shoe Company. A manufacturer, importer, and
distributor of footwear.
In addition to those businesses, Berkshire owned an assortment of smaller businesses8 generating about $400
million in revenues.
Berkshire Hathaway’s Acquisition Policy
The GEICO announcement renewed general interest in Buffett’s approach to acquisitions. Exhibit 4 gives
the formal statement of acquisition criteria contained in the Berkshire Hathaway 1994 annual report. In general,
the policy expressed a tightly disciplined strategy that refused to reward others for actions that Berkshire
Hathaway might just as easily take on its own. Therefore, analysts scrutinized the criteria to assess where they
might offer winning ideas to Buffett.
One prominent example to which Buffett referred was Berkshire Hathaway’s investment in Scott & Fetzer
in 1986. The managers of Scott & Fetzer had attempted a leveraged buyout of the company in the face of a
rumored hostile takeover attempt. When the U.S. Department of Labor objected to the company’s use of an
employee stock ownership plan (ESOP) to assist in the financing, the deal fell apart. Soon the company attracted
unsolicited proposals to purchase the company, including one from Ivan F. Boesky, the arbitrageur. Buffett
offered to buy the company for $315 million, a figure that can be compared to its book value of $172.6 million.
Following the acquisition, Scott & Fetzer paid Berkshire Hathaway dividends of $125 million, even though it
earned only $40.3 million that year. In addition, Scott & Fetzer was conservatively financed, going from modest
debt at the acquisition to virtually no debt by 1994. Exhibit 5 gives the earnings and dividends for Scott &
Fetzer from 1986 to 1994. Buffett noted that in terms of return on book value of equity, Scott & Fetzer would
7 Convertible preferred stock was preferred stock that carried the right to be exchanged by the investor for common stock. The exchange, or
conversion, right was like a call option on the common stock of the issuer. The terms of the convertible preferred stated the price at which common
shares could be acquired in exchange for the principal value of the convertible preferred stock.
8 These included companies in conduit fittings, marketing motivational services, retailing fine jewelry, air compressors, sun- and shade-control
products, appliance controls, zinc die-cast fittings, automotive compounds, pressure and flow measurement devices, fractional horsepower motors, boat
winches, cutlery, truck bodies, furnace burners, compressed gas fittings, and molded plastic components.
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have easily beaten the Fortune 500 firms.9 The annual average total return on large company stocks from 1986
to 1994 was 12.6%.10
Buffett’s Investment Philosophy
Warren Buffett was first exposed to formal training in investing at Columbia University in New York,
where he studied under Professor Benjamin Graham. The coauthor of a classic text, Security Analysis, Graham
developed a method for identifying undervalued stocks (i.e., stocks whose price was less than their intrinsic
value). This became the cornerstone of the modern approach of 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 not recognized by the market.
Over the years, Buffett had expounded his philosophy of investing in his CEO’s letter to shareholders in
Berkshire Hathaway’s annual reports. By 1995, those lengthy letters had accumulated a broad following because
of their wisdom and their humorous, self-deprecating tone. The letters emphasized the following elements:
1. 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 and I, both as owners and
managers, virtually ignore such consolidated numbers…Accounting consequences do not
influence our operating or capital-allocation process.11
Accounting reality was conservative, backward-looking, and governed by GAAP. Investment
decisions, on the other hand, 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; 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 a 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.
2. The cost of the lost opportunity. Buffett compared an investment opportunity against the next best
alternative, the so-called “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 performance.
9 From the comparison firms emerging from bankruptcy in recent years. Buffett’s observation was made in the Berkshire Hathaway annual report,
1994.
10 Stocks, Bonds, Bills, and Inflation.
11 Berkshire Hathaway, Inc., annual report, 1994.
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UV0006
3. Value creation: time is 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 doesn’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
Expanding 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 noneconomic 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 whoever 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 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. Does 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 investment (i.e., Buffett’s book value) indicates
that every dollar invested buys securities worth $1.23. Thus, value has been created.
12
13
Berkshire Hathaway, Inc., annual report, 1992.
Berkshire Hathaway, Inc., annual report, 1994.
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Consider an opposing case, summarized in Exhibit 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. Thus, value has been destroyed.
Comparing the two cases in Exhibits 6 and 7, the difference between 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 economic r …
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