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Analysis of B.H's Acquisiton of GEICO,outdated but worth pondering~

My case study homework 1:Corporate Value

According to Warren Buffet, a company is worth investing only when it creats value.To estimate corporate value,Buffet laid much emphasis on the ecomnomic circumstances.Of the 8 rules of his investing philosiphy,the following four points need special concern when judging corporate value.

1.               Cash Flow.Consistency of cash flow garentees the stability and smoothness of operation.Without sufficient funds as back-ups,even though the company may appear th make profit in the acounting statement,further success and expansion cannot be expected.

2.               Economic Reality.Since accounting reality deals mainly with the past,it is of less use when evaluating corporate potentials and future growth..The econmic reality,on contray, reflects the company’s prospect by taking into account intangible assets.With assets such as franchise,reputation and managerial know-how,the company enjoys some “privilege” when competing with its counterparts.

3.               Management. Able managers can add to corporate value by working to the shareholders’ benefit and helping the company out during crisis.Only in this case can the company survive in the changing market.

4.               Intrinsic Value.The discounted rate should be carefully chosen.The expected annual growth rate in intrinsic values best represents how much return the investors require,therefore is better than the theoretical discounted rate in measuring the intrinsic value.Predictable cashflow is favorable to make a better estimation.

As to GEICO,it is a wise purchase for the following reasons.

1.       GEICO is the 7^th largest auto insurer with a long history.Its market share is considerable,covering 3.7million cars. GEICO’s reputation as the lowest cost insurance provider is valuable intangile assets which would be continuously attracting more clients.

2.       The company’s core business was auto insurance,the inflow of cash ,in form of insurance fee,is of little elasticity.,thus is predictable and smooth.The increasing dividend paid is an indication of increasing cash flow.Since the intrinsic value is discounted cash flow.The larger amount of cash flow, the larger the intrinsic value gains.

3.      GEICO’s managers were sure to bring the company out of trouble,and contribute to both GEICO and Berkshire as qualified successors who would continue Buffet’s value investment.No wonder Berkshire’s stock price increased as a result of the acquisition.

4.      Given the forecasted dividends and stock price in 2000,providing that discounted rate equals 15%(which is the expected annual growth rate),the PV per share is 67.24at the highest, 49.17at the lowest.The “fair”price would be PV*67,889,574(the number of outstanding shares ),about 3.3 billion at minimun and 4.6 at maximun .While Buffet had bought GEICO for only (1.9+2.3)=4.2 billion,the bid price is appropriate. Besides, GEICO’s return on equity from 1980 to 1994exceeds the average 13.5% .

From the above,we can reach the conclusion that GEICO is actually a promising company with great corporate value.