Topics: Stock market, Time value of money, Warren Buffett Pages: 20 (3090 words) Published: March 18, 2013

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 investment’s future potential.

Review of Warren Buffett’s 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. Buffett’s investment success may add to shareholder’s comfort, as his track record is remarkable when compared to broader market results.

Buffett’s investment philosophy. A letter to shareholders gives us a unique look at Buffett’s 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. Buffett’s position on GEICO’s 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 Line’s 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 GEICO’s 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)

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 + β 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 GEICO’s stock will...
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