BERKSHIRE HATHAWAY PURCHASES GEICO

WARREN BUFFET Executive Summary Berkshire Hathaway has made a bid for the remaining portion of GEICO stock. This report reviews the offer initiated by Warren Buffett. The details of this report include: Valuation of GEICO stock. The $70 offer made by Warren Buffett and Berkshire Hathaway includes a 26% premium over the current GEICO stock price of $55.75. This report attempts to determine a range of appropriate stock prices for GEICO. Using the Gordon dividend discount model, along with historical dividend information and projections by Value Line, we estimate the value of GEICO stock in the range of $58 to $80. A review of historical growth rates in GEICO dividends also lends credibility to the investments future potential. Review of Warren Buffetts investment record. While our analysis lends credence to the bid price of $70 per share for GEICO, we also examine the historical record of Warren Buffett. Buffetts investment success may add to shareholders comfort, as his track record is remarkable when compared to broader market results. Buffetts investment philosophy. A letter to shareholders gives us a unique look at Buffetts considerations for investing. By reviewing his checklist, we attempt to gain insight as to why such a premium is included in the GEICO offer. Other issues. Buffetts position on GEICOs board of directors may shed light on the amount of information Buffett had about the future prospects of GEICO. At first glance, there appears to be some support for a higher price for GEICO. Value Lines publication shows that the offer price is reasonable and historical growth rates may indicate reason to be optimistic However, only time will tell.

GEICO Valuation GEICO Corp. currently sells for $55.75. The bid price of $70 per share represents a 26% premium over the existing share price. We look at the value of GEICO shares in two separate ways: 1. Reaction of Berkshire Hathaway share price 2. Dividend discounting techniques Market Reaction If the bid price of $70 was perceived as too high, any excess price would be at the detriment of the shareholders of Berkshire Hathaway. We would expect the market to react negatively to the announcement, dropping the share price. But in fact, the market value of Berkshire Hathaway increases $718 million after the announcement. This reaction includes two components: (1) the increase in value of GEICO shares already owned by Berkshire Hathaway (34.25 million-shares) and (2) additional benefits of buying GEICO at only $70 per share. Since Berkshire Hathaway already owns some shares, part of the market reaction would include the reassessment of GEICOs value: Gain due to existing shares = 34.25 mil * (70.00-55.75)=$488 million The remaining increase in value for Berkshire Hathaway represents added value given that the company has paid only $70 per share: (718 mil 488 mil) = 67.9 mil * (P-70.00) P=$73.39

Judging from the market reaction, it appears that Berkshire Hathaway shareholders agree with Warren Buffett's offer. In fact, they appear to be implying that the $70 bid was a good deal.

Value Line Projections Instead of implying prices from market reactions, we can perform our own analysis to estimate the current stock price (P0). The valuation of any security is the present value of expected cash flow. For stocks, the expected cash flows are dividends and the projected future sales price. We assume that the discount rate can be derived using the capital asset pricing model:

r = r f + rm r f

From footnote #32 in the case, we estimate the required return on GEICO stock as:
r = 6.86% + 0.75[5.50%] 11%

We recognize that there may be other ways to estimate the market capitalization rate for GEICO, but we are given no other information in the case. For the rest of our analysis, we assume the risk-adjusted discount rate for the cash flows from GEICOs stock will be 11%, as estimated above. For the first estimate of the stock price, we discount the estimates of future dividends and stock prices from Value Line. The top of Exhibit 1 (attached) shows the calculations from discounting the Value Line estimates. Under the low projections, the current stock price is estimated as $58.32; under the higher projection, would the current value is $79.85. Thus, the offer price of $70 appears right inline with the (publicly available) information available in the Value Line Investment Survey. It is also

interesting to note that even under the low projection of Value Line, the current market price of $55.75 seems low.

Dividend discount model valuation

The Gordon model makes several assumptions about the valuation of stock.

The stock price (P0) is the present value of expected cash flows (dividends) Dividends grow at a constant rate g

In order to calculate the value of GEICO stock using the dividend discount model, we need an estimate of the first dividend, the growth rate in dividend, and the discount rate. One of the more difficult assumptions is the future growth rate. The bottom of Exhibit 1 and Exhibit 2 analyzes the growth rate for input into the Gordon model. The bottom of Exhibit 1 uses the Value Line Information to derive the implied growth rate in two ways. First, one can estimate the projected growth rate of dividends forecasted over the next four years. For example, the compound growth rate under the lower projection can be determined by:
1.55 = (1 + g ) 4 1.16 g ( low) = 7.51%

Under the high projection, the implied growth rate in dividends is 15.58%. A second growth rate is implied in the terminal value of the stock forecasted by Value Line. If Value Line uses the Gordon model to estimate the stock price at the end of the year 2000, we can rearrange the model to imply what Value Line used for long-term future growth.

P 2000

D 2001 k g D 2001 g = k P 2000 =

Thus, under the low projection:

g = 11%

1.55 (1 + 0.0751) = 9.15% 90.00

Under the high projection, the implied long-term future growth is 9.09%, indicating that long-term prospects of GEICO are similar under the two different Value Line projections. For another estimate of the growth rate, we can see what is implied by the current market price.
g=k D1 1.16 = 11% = 8.91% P0 55.75

At this point, we have several indications of future growth near 9%. Plugging this estimate into the Gordon model we estimate the current stock price at $58.00, only slightly above the current market price and well below Berkshire Hathaway is bid price of $70 per share. It seems reasonable than if Berkshire Hathaway is going to offer a premium over the existing stock price of the $55.75, it may be that Warren Buffett is projecting higher growth than is anticipated by the market or Value line. Exhibit 2 (attached) shows the historical dividends of GEICO. Given the sharp increase in 1994 dividends, we perform two growth rate calculations: one including and one excluding the year 1994. Regardless of the time frame, GEICOs historical increase in dividends has been much higher 9%. While it is clear that strong growth cannot continue indefinitely, Buffetts offer for the

remaining shares of GEICO may indicate that he strongly believes that growth rates will be higher than 9%. Finally, we imply what growth rate is needed over the long-term to justify the offer price of $70. If we assume that the first dividend is the same as last years $1.00 per share:
g = 11% 1.00 = 9.57% 70.00

This value shows that even if the dividend doesnt change next year, if future dividends grow by only 9.57%, this would justify a stock price of $70 today. Note that this growth rate is only slightly different from the long-term Value Line projections. The calculation also shows how sensitive the DDM is to small changes in the growth rate as highlighted in the following table:
Projected growth rate (g) D1= $1.00 and k=11% 9% 9.25% 50.00 57.14

Current Stock Value

8.75% 40.00

9.75% 80.00

The implied growth rate of 9.57% from Buffetts offer seems reasonable based on historical performance and Value Lines projections.

Buffetts Historical Record

Our analysis suggests that Buffetts offer price seems reasonable despite the large premium. We also consider the historical record of Buffett to determine if he has a habit of overpaying for his investments. His record may also help interpret the positive market reaction to the GEICO announcement.

We consider first the overall experience of Berkshire Hathaway, which is (very, very loosely) a holding company for investments of Warren Buffett. If Buffett has had a good track record, we would expect Berkshires shareholders to respond positively. In 1977, the price of Berkshire Hathaway was $89 and in 1995, the price was a whopping $25,400, implying a compound annual growth rate of 37.7% over the 17.66 year period (see the specific dates in the case).
25,400 = (1 + g )17.66 89 g 37.7%

In comparison, the growth rate of the S&P 500 over the same period was 14.3%. The historical growth rate of Berkshire Hathaway provides shocking evidence of Buffett's formidable investment performance. The acquisition of Scott & Fetzer provides for an analysis of a single investment decision. Using information about the dividends provided in the case, we can calculate a rate of return of using an internal rate of return methodology (see Exhibit 3). The internal rate of return (IRR) determines the compound annual return on an investment after accounting for intermittent cash flows. Berkshire Hathaway paid $315 million for Scott & Fetzer in 1985; since then, theyve received significant dividends. We would like to know what rate of return this $315 million has earned. To determine the IRR, we need to find the discount rate that equates the present value of all of these cash flows with the price paid.
315 = 125 41 35 71.50 33.50 + + + + 1 2 3 4 (1 + IRR) (1 + IRR) (1 + IRR) (1 + IRR) (1 + IRR) 5 74 80 98 76 + + + + 6 7 8 (1 + IRR) (1 + IRR) (1 + IRR) (1 + IRR) 9

Ignoring any dividends after 1994, we find the IRR is 14.9%, which exceed the markets return over the same period. However, this ignores all future dividends of Scott & Fetzer. We can estimate future dividends by calculating a terminal value, assuming that 1994s dividend will continue forever. The present value of this perpetuity of $76 million, discounting at Berkshire Hathaways cost of capital of 12% is over $600 million. When included in the 1994 cash flow, this increases the IRR on the Scott & Fetzer investment to a whopping 26.4%. Finally, to gain even further insight into Buffetts history, we can also look at the specific experience of owning GEICO. In 1976, Buffett paid $45.7 million for 34.25 million shares of GEICO. In the bottom of Exhibit 3, we review the cash flows earned (dividends) from investing in GEICO stock. The final cash flow would also include the current value of the shares already owned by Berkshire Hathaway. The exhibit shows the IRR of investment in GEICO based on three different values for the current stock price. In all cases, it is clear that GEICO has been a very profitable investment for Berkshire Hathaway shareholders.

Other issues

Earlier in the report could, we saw that Berkshire Hathaway's shareholders drastically revised its valuation of GEICO stock from $55.75 to $70. Such a dramatic reassessment may be explained by Buffett's position on the board of directors at GEICO. The bid by Buffett may reveal that he possessed inside information about the companys future growth as a result of his position. The bid represented a signal to the market of a more optimistic outlook than was originally held. In effect, this

may have biased outside investors to tilt more toward the high Value Line projections. Clearly there may be significant issues related to a change in ownership of a company. But the announcement of the purchase suggests that there will be neither major changes in the operations of GEICO nor any specific economies of scale with existing insurance operations owned by Berkshire Hathaway. We conclude that little or no resentment stemming from ownership changes and no effect on future stock performance.

Buffetts Investment Philosophy

The letter to shareholders explaining Buffett's investment philosophy may provide further insight into Buffetts historical record or more specifically help interpret the offer for GEICO. Buffetts philosophy has many similar themes to modern financial theory. He talks about the shortfalls of GAAP accounting, the importance of time value money, the importance of incremental cash flow valuation, and the alignment of shareholders and managers. However, Buffett suggests three elements of modern finance which he believes to be false. 1. Risk adjusted discount rates. Rather than adjusting the discount rate to reflect the risk of investment cash flows, Buffett appears to use a risk free rate for valuation purposes. He supposes that with careful analysis, the cash flows can be predicted with a high degree of accuracy. We interpret this belief as a blatant disregard of risk. The result of ignoring risk adjustments are that valuations may be too high, since the present value of projected cash flows is discounted at a lower rate. Using risk

adjustments may lower the initial investment in many assets. While Buffetts record is undeniable, we questioned whether the record might have been even more favorable if Buffett used risk-adjusted discount rates. 2. The benefits of portfolio diversification. Buffett abhors diversification when he says "Diversification is protecting against ignorance. If you don't feel ignorant [about investing in the company since you did thorough analysis] the need for diversification goes down drastically." While Buffett shuns the benefits of portfolio diversification, the holdings of Berkshire Hathaway actually indicate that he practices diversification more than he preaches. Exhibit 2 in the case provides information about 10 major investments accounting for 60% of the firm's earnings. The holdings indicate a wide range of products including insurance, retail clothing, publishing, and consumer goods. These seemingly unrelated investments would appear to provide significant diversification benefits. 3. Stock market efficiency. Buffett mocks universities which advocate market efficiency. Buffett disagrees that available stock prices are fair predictors of the true value of companies. He believes there is tremendous opportunity for actively pursuing higher returns and diligent research before investment. However, market efficiency theory suggests that passive portfolio management (simply investing in a broad stock market index) is as good as any investor can do. Taken together, we believe that Warren Buffett has tremendous faith in his investment process. But the contradictions to modern finance (mentioned above) imply that when he invests, he has a tremendous informational advantage. If he does has an informational advantage, this may imply that that markets may still be efficient, he is simply benefiting

from insider information. While we believe that informational advantages can help in the short-term, we felt skeptical extrapolating these benefits too far. However, as the

historical experience in the previous section illustrates, we also find it difficult to argue with the confidence that Warren Buffett attributes to his philosophy.

Conclusion

The 26% premium included in the offer for GEICO stock may, at first, seem high. However, our analysis supports the offer of $70 per share. Using Value Line projections, our estimate of the stock price is between $58 and $79. In order to justify the offer, the future growth rate of GEICO must be approximately 9.57%. Given recent history and projections by Value Line, this growth rate appears quite attainable. Also, Buffetts current insider position at GEICO and his tremendous track record lend more confidence to the offer. If we were a shareholder in Berkshire Hathaway, we would approve this purchase and anticipate strong future returns from the acquisition.

EXHIBIT 1
DIVIDEND DISCOUNT MODEL VALUATION OF GEICO
PRESENT VALUE OF VALUE LINE PROJECTIONS Year 1996 1997 1998 1999 2000 Terminal Value 2000 Current Stock Value Low Proj PV 1.16 1.05 1.25 1.01 1.34 0.98 1.44 0.95 1.55 0.92 90.00 53.41 58.32 Hi Proj PV 1.16 1.05 1.34 1.09 1.55 1.13 1.79 1.18 2.07 1.23 125.00 74.18 79.85

IMPLIED GROWTH RATES FROM VALUE LINE ESTIMATES Low Proj High Proj 7.51% 15.58% 9.15% 9.09%

Projected Dividend Growth Implied from Terminal value

Implied Market Growth

8.92%

GORDON MODEL VALUATION k=11%, g=9%, D1=1.16 DDM 58.00

EXHIBIT 2
HISTORICAL DIVIDENDS OF GEICO
Year 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 Dividend 0.01 0.04 0.07 0.09 0.10 0.11 0.14 0.18 0.20 0.22 0.27 0.33 0.36 0.40 0.46 0.60 0.68 1.00 Annual Growth

300% 75% 29% 11% 10% 27% 29% 11% 10% 23% 22% 9% 11% 15% 30% 13% 47%

Period 5 yr 10 yr 15 yr

Compound Growth Rate Include 1994 Exclude 1994 22.7% 15.6% 18.7% 17.1% 19.4% 20.8%

EXHIBIT 3
Historical Investments SCOTT & FETZER
Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 Term Val IRR (no TV) IRR (with TV) Mkt Dividend (315.00) 125.00 41.00 35.00 71.50 33.50 74.00 80.00 98.00 709.33 633.33 14.9% 26.4% 12.6%

HISTORICAL RETURNS ON GEICO

Time 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 Current Price 55.75 70.00 73.39 Div 0.01 0.04 0.07 0.09 0.10 0.11 0.14 0.18 0.20 0.22 0.27 0.33 0.36 0.40 0.46 0.60 0.68 1.00 Stock Value 1,909.44 2,397.50 2,513.61 BRK CF (45.70) 0.34 1.37 2.40 3.08 3.43 3.77 4.80 6.17 6.85 7.54 9.25 11.30 12.33 13.70 15.76 20.55 23.29 34.25 IRR 25.6% 26.9% 27.2%