Case 2: Warren E. Buffett.
The possible meaning of the change in the stock price of Berkshire Hathaway on the day of the announcement is that the shares of GEICO were undervalued at a price of $55,75 and Berkshire Hathaway paid a $14,25 premium per share. However, even though Berkshire Hathaway paid $70 per share, that price was lower than the fair value of GEICO but the shareholders couldn’t turn the offer down. Consequently, Berkshire Hathaway increased it’s market value by $718 millions because the intrinsic value of GEICO was higher than the price it was sold for.
The company had outstanding 1,177,750 shares and on august 25 BH share price changed by positive $609.60. At the end of the session, the price was $25,400.
1,117,750 * 609.60 = 717,956,400 gain.
...view middle of the document...
And GEICO had a value of
Resulting to the total BH+GEICO = 29,914.85+2357.13 = $32,271.98 million and the difference is 32,271.98-31,074.17 = $1,197.81
The difference is coming from the GEICO shares
Difference/total GEICO shares
1,197.81 million / 33,673,229=$35.57 mispricing per share and GEICO shareholders only got $14.25 of this value. The $21.32 went to BH shareholders.
Buffet’s investment philosophy disagrees with modern financial theory because in his CEO letter to shareholders in BH’s annual report he emphasized on various element. First, he ignores consolidated numbers such as balance sheet and income statement and values intangible assets (patents, trade marks, reputation and so one) whereas most executives cherish consolidated numbers.
Second, he measures performance by gain of intrinsic value not like other executives who favor accounting profit.
Also, Warren Buffet does not believe in the practice of diversification to reduce company-specific risk in a portfolio. Instead he was convinced that if you “do not feel ignorant, the need for diversification goes down.”
He also proved that he was able to adapt for his own use conventional tools. He modified the CAPM and used US treasury bonds to avoid risks.
However, he agrees on several modern financial theories such as: time value of money, cost of lost opportunity, investments based on information and not emotions and alignment of agents and owners.
BH shareholders should endorse the acquisition of GEICO simply because during the day of the announcement of the acquisition, the BH share experienced a $609 growth. In addition, the expected internal rate of return is 19%: it means that the future of GEICO is expected to be good.
For example, if a shareholder of BH detains 10 shares he will get $6,090 profit in a day!