Case 1: Warren Buffett
Warren Buffett's (Buffett) track record as a value investor and sheer financial strength has earned him an incredibly valuable reputation within the financial industry. Being an anomaly in the investment world; when he talks – the market follows.
This is noticeably seen in the increase in equity of $718 million.
GEICO Outstanding shares April 30, 1995: 67.89 million, of which 34.22 million owned and 33.67 million purchased at $70; total price $2.3 billion.
A Capital Asset Pricing Model (CAPM) derived cost of equity equaled 10.99% percent via a risk-free rate of 6.86 percent, a beta of 0.75, and an equity risk premium of 5.5 percent.
k = 6.86 + 0.75 ((5.5)) = 10.99%
Using Value Line’s forecast & the above discount rate and share information: the following low end & high end NPV are calculated:
Low end: -$335.57
High end: $389.89
For methodology in calculation of intrinsic value refer to ‘1995-Question 2’ in the accompanying “excel“spreadsheet for the analysis.
Using Value lines cost of equity; the investment yields a negative Net Present Value (NPV) on the low end. The investment will not add value to the firm and the acquisition of GEICO doesn’t seem to be a good one. The high end range yields a positive NPV showing the investment rather is rather a prudent one.
The discount rate used is highly subjective and is influenced by the risk premiums chosen by the analyst. If we increase the risk premium on the cost of equity we will see negative NPV for both the high and low end range; finding the investment unsuitable.
Buffett calculated the intrinsic value using the risk free rate of 6.86%. Looking at “1995 excel spreadsheet”; using the risk free rate of 6.86%, both the high and low end ranges the investment yields a positive Net present Value;...