Case 1: Warren Buffett

CASE 1: Warren Buffett

From Warren Buffett’s perspective, what is the intrinsic value? Why is it accorded such importance? How is it estimated? What are the alternatives to intrinsic value? Why does Buffett reject them? (2 Marks)

From Warren Buffett’s perspective, intrinsic value is “the present value of future expected performance” (Bruner, Eades & Schill 2013, p. 7). Intrinsic value is based on fundamental analysis of what the true value of a security actually is, without regard to the market view. Intrinsic value is accorded such importance as it enables investors to determine whether stocks are over or undervalued by the market, and to trade accordingly.

Intrinsic value is estimated by estimating future cash flows, and then discounting these by the appropriate discount rate, which should represent the risk of the cash flows being valued. Conventionally the appropriate discount rate is calculated using the capital asset pricing model (CAPM: see appendix 1), which includes a risk premium on top of the long-term risk-free rate of return (Bruner, Eades & Schill 2013, p. 9). The intrinsic value is then estimated as the sum of these discounted future cash flows.

The alternatives to intrinsic value are book value, which is the accounting value that a business is carried at, or stock prices, which are the current prices of stock in the share market. Buffett rejects book value as a measure of performance as book values “may not reflect the economic reality” (Bruner, Eades & Schill 2013, p. 8), rather, they are based on historical pricing. Similarly, Buffett rejects the use of daily stock prices, as these do not provide an accurate measure of intrinsic value. Instead these prices are “heavily influenced by momentary greed or fear” (Bruner, Eades & Schill 2013, p. 10).

Critically assess Buffett’s investment philosophy. Identify points where you agree and disagree with him. (2 Marks)

Buffett’s investment philosophy, in essence, is to identify...