Case Studies in Finance
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In the event of MidAmerican Energy Holdings Company acquired PacifiCorp, the market believed that it was a good deal for both Berkshire Hathaway Inc., parent of MidAmerican, and Scottish Power, parent of PacifiCorp.
On the day that Warren Buffett (the chairperson and CEO of Berkshire Hathaway) announced the acquisition of PacifiCorp, Berkshires Class A share price went up by 2.4%, which accounted for a $2.55 billion increase in Berkshires market value. Additionally, the targets parent companys stock price was also increased by 6.28% on the same day. The increase of both bidders and targets stock price could be regarded as the market perceived positive synergies of the deal for both parties.
The first step to determine if this is a good deal or not is to find out the intrinsic value of PacifiCorp. The $2.55 billion value increase equals an appreciation of $8.17 per PacifiCorp share of stock (EXHIBIT 1), together with the bidders offer of $5.1 billion, which equals $16.34 per share, this implies the intrinsic value of PacifiCorp is $24.51 per share.
Besides calculating the intrinsic value of PacifiCorp based on the gain in equity, we can also calculate the value of PacifiCorp based on the multiples for comparable regulated utilities, and the range of possible values for PacifiCorp is summarized in EXHIBIT 2. For comparison, we pick the market value equity as multiple of EPS, as it follows the economic reality and the foreseeable profitability. Thus, the range of possible values for PacifiCorp should be between $4,277 million and $4,308 million.
Moreover, other than multiples approaches, we can also evaluate the value of PacifiCorp based on its financial statements and calculate the free cash flow of it. As the case did not provide enough information for PacifiCorps cost of debt and equity, we evaluated them by the information given.
According to the data given by the case, EBIT of PacifiCorp as calculated is $656.4 million and the interest expense in 2005 is 236.2million. Therefore, the interest coverage ratio is 656.8 / 236 = 2.78. According to EXHIBIT 3, for a large firm, a 2.78 interest coverage corresponds to a BBB rating or 2.25% over T-bonds (5.76%). Therefore, the cost of debt of PacifiCorp will be approximately 5.76% + 2.25% = 8.01%. And following the cases assumption, the cost of equity would be 15%. Supposed the firm is steady growing in 2005, firms value = FCF / WACC (g) + other assets = 235 / 9.9% + 1816 = $4.2 billion (EXHIBIT 4 shows the calculation of free cash flow). The result is very close to the range of values based on the EPS multiple approach.
In order to make the offer from Berkshire Hathaway comparable, we need to discount the $5.1 billion offer. According to the data given in the case, it is possible to calculate the discount rate by CAPM which is 9.32%. The case mentioned that the acquisition would be completed sometime in the next 12 to 18 months, so the present value of the $5.1 billion offer should be between $4.5 billion and $4.7 billion (EXHIBIT 5).
According to the implied value of PacifiCorp based on the multiples for comparable regulated utilities, the bid seems to be a little bit higher. The reason may be because of that PacifiCorp was a private company and its potential growth may be greater than the other listed companies in the industry. So a little bit higher offer than the estimated value is reasonable. Therefore, the market reaction may be a little bit overactive with this fair bid. One possible reason is the positive synergies perceived by the market, which was mentioned above. However, there are many regulatory constraints in the utility industry such as the Public Utility Holding Company Act of 1935 (1935), so this may not be the major reason. Another possible reason is the historical performance of Warren Buffett aroused peoples belief.
Despite the acquisition, we take a look at the overall performance of Berkshire Hathaway. From 1965 to 2004, there is a 24% compound annual increase in wealth for Berkshire Hathaway. It is more than double of the annual average total return on all large stocks, which is only 10.5% within the same period.
For a more detailed evaluation of Berkshire Hathaway, we take a look at the investment of Berkshire Hathaway in “Big Four”: American Express, Coca-Cola, Gillette, and Wells Fargo. All the transactions was occurred in between May 1988 and October 2003. The compound annual increase in wealth is 16.07% for this 15.5-year period (EXHIBIT 6), which is also greater than the 10.5% mentioned above. Therefore, the move of Warren Buffett is worth consideration.
As the case mentioned, Buffett thinks that the intrinsic value is the present value of future expected performance. To estimate the intrinsic value, Buffett encouraged discounting free flows of cash of the business. First, we estimate the future free cash flow of every year, and then specifying the discount rate such as the long term