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Solution To Case Stury Warren Buffett

1354 words - 6 pages

Assessment of the eight major elements of Buffet's investment philosophy:

1 Economic reality, not accounting reality.

Analysis:

One tends to agree with Buffett on this philosophy.
Accounting is a product of many estimates and judgments. It is essentially a rear-view mirror, looking back at what has happened. To add to the problem the view changes with each new accounting period.
In contrast the economic reality is the view through the windshield at what lies ahead. It consists of intellectual property, creativity, know-how and the network of production and distribution systems. The brands and trademarks of a business are the symbols of the economic reality – symbols that ...view middle of the document...

The rate of return received from an investment is the profit divided by the cost of the investment. Positive NPV investments will have rates of return higher than the opportunity cost.

4. Measure performance by gain in intrinsic value, not accounting profit.

Analysis:

Here the gain in intrinsic value being referred to is similar to the ‘EVA’ , ‘economic profit’ or ‘market value added,’ measures which are used by financial analysts to assess financial performance. These measures focus on the ability to earn returns in excess of the cost of capital. The difference between a company's return and its cost of raising capital is called "EVA" (Economic Value Added). Unlike traditional accounting measures, (EPS and ROI) EVA focuses on economic profit rather than accounting profit and hence calculates shareholder value creation/destruction over the relevant period of time. In other words when we measure performance by gain in intrinsic value we are estimating the amount by which earnings exceed or fall short of the rate of return shareholders and lenders could get by investing in other securities of comparable risk. Thus it builds on the concept of opportunity cost.

5. Risk and discount rates.

Here one would disagree with Buffett.
Risk and return is one of the basic principles in finance. Risk and return are directly related. The greater the risk that an investment may lose money, the greater its potential for providing a substantial return. By the same token, the smaller the risk an investment poses, the smaller the potential return it will provide. Thus there are different classes of investment depending on their risks.
Buffett may argue that he avoids risk by focusing on companies with predictable and stable earnings and being a large investor he can sit on the boards of directors where he obtains a candid, inside view of the company and could intervene in decisions of management if necessary but this option is not available to all investors especially small ones. Therefore it is not prudent to discount all future cash flows at the risk free rate.

6. Diversification.

Analysis:
One tends to agree with Buffett on this philosophy.

Diversification is a basic principle in investing the idea being that since you cannot possibly know beforehand which stocks will perform better or worse than the average, you cannot afford to put all of your money into one company, or even in companies within a single industry. One resorts to diversification to spread the risk -- and opportunity. The average returns are obtained by diversifying.

Buffett challenges the conventional wisdom regarding diversification. He argues that holding a few good stocks is far more important than spreading funds across a broad number of stocks. It is a fact that investors have been so oversold on diversification that the fear of having too many eggs in one basket has caused them to invest very little into companies about which they...

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