Warren Buffett often refers to Berkshire Hathaway's (WKN:A0YJQ2) book value as a measure of success or failure, but even he admits that this method has its flaws.
One of the biggest flaws in the system is that acquisitions that make losses are devalued, but winners can't be upgraded. Therefore, Berkshire's book value captures many of its failures, but none of its greatest successes in acquisitions.
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Few success stories are as important as Geico, which has grown by leaps and bounds since Berkshire acquired it in 1996. But as Buffett wrote in his 2010 letter to shareholders, Geico never reflected its success and is valued at a premium of just $1.4 billion to its book value.
What would Geico be worth if Berkshire were willing to sell it? We can use a method Buffett laid out in his letter to shareholders in 2010 to estimate value.
Valuing Geico like Buffett
Geico is a highly profitable insurance company that is truly in a league of its own. Any buyer would pay far more than the liquidation value to own it, given its exceptional customer record and growing earning power.
In his 2010 letter, Buffett shed light on how he felt about the $4.6 billion effective price Berkshire Hathaway paid for the company in 1996. He wrote that he valued Geico's intangible assets at 97% of annual premium volume at the time of the acquisition.
Using the same method today, Geico should be worth about $29.3 billion more than book value, based on premiums written in the most recent quarter. That values the brand and its customers at about 20 times the $1.4 billion reported on its balance sheet.
Is this too high? Possibly. Consider that Geico faced far greater growth in 1996 than it does today. Self-driving cars weren't even a thought 20 years ago, but now we're thinking about when cars could drive themselves and how much we'll save on insurance if they do.
What's more, Berkshire could afford to pay a premium for the part of Geico it didn't own in 1996. Here's how to eliminate taxation on dividends Geico paid to Berkshire. There are many reasons to believe the historical metric is too high to use today.
But before we conclude that valuing Geico's intangible assets at 97% of contributions is completely unrealistic, let's put it to the test. We can use Buffett's method to value a comparable insurance company like Progressive Insurance (WKN:865496) and see if the resulting valuation is too high or too low.
Progressive is a well-run insurance company that generates most of its premiums from car insurance, just like Geico. What Progressive lacks in cost control (about half of its business comes from expensive brokers), it makes up for with low loss ratios. Geico and Progressive have been extremely profitable compared to their peers, and both have grown at a respectable double-digit percentage in contributions.
Interestingly, Progressive has a current market cap of approx. 31.8 billion U.S. dollars, which is ehr close to the valuation we get if we use Buffett's methodology.
|Posts (Annual Highlight Q3 2017)||26.2 billion USD|
|Value intangible||25.4 billion USD|
|Tangible book value||8.4 billion USD|
|Progressive valuation based on Buffett's method||33.8 billion USD|
DATA SOURCE: SEC FILINGS. AUTHOR'S CALCULATIONS.
The fact that Progressive's current market capitalization is only about. U.S. dollars (7%) lower than Buffett's, one could attribute that to the fact that such a high value of customer relationships, branding and other intangible assets is not entirely unreasonable for a high-value insurance company.
The 52 billion dollar gecko
Berkshire Hathaway does not separately disclose the balance sheets of its insurance companies in its quarterly reports, but based on disclosures to the SEC, we can estimate. Geico and its subsidiaries had a surplus (equity) of $23 billion at the end of 2016. Adding the $29.3 billion value of Geico's brand and customer relationships, calculated using the Buffett method, Geico could be worth a total of $52.3 billion.
The hidden value of Geico's brand and customer relationships goes a long way toward explaining why Buffett believes Berkshire Hathaway is an attractive investment even at prices above book value. Buffett has said he would like to buy back shares of Berkshire at 1.2 times book value, and in the past he has done just that.
Last quarter, Berkshire's book value was $311.9 billion. Buffett thinks fair value is at least $62.4 billion higher, based on his belief that shares are a good buy at any price less than 1.2 times book.
If Geico is really worth $27.9 billion more than its book value ($29.3 billion according to Buffett's methodology, minus $1.4 billion in intangible assets already on Berkshire's balance sheet), that accounts for nearly half of the $62.4 billion difference between Berkshire's book value and Buffett's valuation.
It is quite clear that Geico's intangibles, including Gecko, are very important to Berkshire.
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The Motley Fool holds and recommends Berkshire Hathaway (B shares).
This article was written in English by Jordan Wathen and published on 10.12.2017 on Fool.com published. It has been translated so that our German readers can participate in the discussion.
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