Showing posts with label GEICO. Show all posts
Showing posts with label GEICO. Show all posts

Monday 15 October 2012

How to Determine the VALUE? Illustrated by Buffett's investment in GEICO.

GEICO

1976

When Buffett started buying GEICO, the company was close to bankruptcy.

But he says GEICO was worth a substantial sum, even with a negative net worth, because of the company's insurance franchise.

In 1976, the company had no earnings, and this defied a mathematical determination of value as put forth by John Burr Williams.

Williams postulated that the value of a business is determined by the net cash flows expected to occur over the life of a business discounted at an appropriate rate.  

Despite the uncertainty over GEICO's future cash flows, Buffett was sure that the company would survive and earn money in the future.  

How and when was open to speculation.


1980

In 1980, Berkshire Hathaway owned one-third of GEICO, invested at a cost of $47 million.   That year, GEICO's total market value was $296 million.  

Even then, Buffett estimated that the company possessed a significant margin of safety.

In 1980, the company earned $60 million on $705 million in revenues.  Berkshire's share of GEICO's earnings was $20 million.

According to Buffett, "to buy a similar $20 million in earnings in a business with first class economic characteristics, and bright prospects would cost a minimum of $200 million" - more if the purchase was for a controlling interest in a company.


Let's look at Buffett's $200 million assumption.  Is it realistic, given the theory by Williams?

Assuming that GEICO could sustain this $60 million in earnings without the aid of any additional capital, the present value of GEICO, discounted at the then-current 12% rate for a thirty-year U.S. government bond, would have been $500 million - almost twice GEICO''s 1980 market value.

PV (no growth)
= $60 / 12% 
= $500 million.

IF the company could grow this earnings power at 2% real, or at 15% before current inflation, the present value of GEICO would increase to $600 million, and Berkshire's share would equal $200 million.  

PV (2% earnings growth rate)
= $60 million / (12%-2%) 
=  $60 million / 10% 
= $ 600 million.


Conclusion

In other word, in 1980, the market value of GEICO's stock was less than half the discounted present value of its earnings power.