Murphy was named president of Capital Cities in 1964.
Murphy agreed to sell Buffett 3 million shares of Capital Cities/ABC for $172.50 per share.
How Buffett determined the combined value of Capital Cities and American Broadcasting
Approximate yield of the thirty-year US government bond in 1985 = 10%.
Cap Cities had 16 million shares = 13 million shares outstanding plus 3 million issued to Buffett.
Market cap = 16 million x $172.50 = $ 2760 million
The present value (intrinsic value) of $ 2760 million of this business would need to have earnings power of $276 million. ($2760 x 10%)
1984
Capital Cities earnings net after depreciation and capital expenditures = $ 122 million.
ABC net income after depreciation and capital expenditures = $ 320 million.
Combined earnings power of these two companies = $ 442 million.
However, the combined company would have substantial debt: the approximately $ 2.1 billion that Murphy was to borrow would cost the company $ 220 million a year in interest.
So, the net earnings power of the combined company = approximately $200 million.
Additional considerations
Capital Cities’ operating margins were 28%.
ABC’s operating margins were 11%.
If Murphy could improve the operating margins of the ABC properties by one-third to 15%, the company would throw off an additional $125 million each year, and the combined earnings power would
= $ 200 million + $ 125 million
= $ 325 million annually.
The present value of a company earning $ 325 million annually discounted at 10%
= ($325 million / 10%)
= $3250 million.
The per share present value of a company earning $ 325 million with 16 million shares outstanding
= $ 325 million / 16 million
= $ 203 per share.
This gives a 15% margin of safety over Buffett’s $ 172.50 purchase price.
The margin of safety that Buffett received buying Capital Cities was significantly less compared with other companies he had purchased. So why did he proceed?
Murphy was Buffett’s margin of safety. When Capital Cities purchased ABC, Murphy’s talent for cutting costs was badly needed. With the help of carefully selected committees at ABC, Murphy pruned payrolls, perks, and expenses. Once a cost crisis was resolved, Murphy depended on his trusted manager to manage operating decisions. He concentrated on acquisitions and shareholders assets.
Appendix
The margin of safety that Buffett accepted could be expanded if we make certain assumptions.
1. Buffett says that conventional wisdom during this period argued that newspapers, magazines, or television stations would be able to forever increase earnings at 6% annually - without the need for any additional capital. The reasoning, explains Buffett, was that capital expenditures would equal depreciation rates and the need for working capital would be minimal. Hence, income could be thought of as freely distributed earnings. This means that an owner of a media company possessed an investment, a perpetual annuity, that would grow at 6% for the foreseeable future without the need for any additional working capital.
Media company
Earned $ 1 million
Expected to grow at 6%.
The appropriate price to pay would be $25 million dollars for this business.
Calculation:
Present value
= $ 1 million / (risk free rate of 10% - 6% growth rate)
= $ 1 million / 4%
= $ 25 million
Compare that, Buffett suggests, to a company that is only able to grow if capital is reinvested.
Another business
Earned $ 1 million
Could not grow earnings without reinvested capital
The appropriate price to pay would be $ 10 million dollars for this business.
Calculation:
Present value
= $ 1 million / risk free rate of 10%
= $ 10 million.
Apply the above to Cap Cities
Calculations:
6 million outstanding shares
Earned $325 million or $ 203 per share
Growth 6%
Risk free rate 10%
Present value = $325 million / (10% - 6%) = $ 8125 million
Per share value = $ 507 per share.
Present value increases from $ 203 per share to $ 507 per share.
Buffett paid $ 172.50 per share. ($172.50 / $ 507 = 34%). Therefore, he enjoyed a 66% margin of safety over the $172.50 price that Buffett agreed to pay.
But there are a lot of "ifs".
However, the margin of safety that Buffett received buying Capital Ciies was significantly less compared with other companies he had purchased.
His ability to obtain a significant margin of safety in Capital Cities was complicated by several factors.
1. The stock price of Cap Cities had been rising over the years. Murphy was doing an excellent job of managing the company, and the company's share price reflected this. (So, unlike GEICO, Buffett did not have the opportunity to purchase Cap Cities cheaply because of a temporary business decline.
2. The stock market didn't help, either. And, because this was a secondary stock offering, Buffett had to take a price for Cap Cities' shares that was close to its then-trading value.
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