investment analysis

1 Introduction to Cases and Questions BUS 172A (Investment Analysis) Description (Warren E. Buffett, 1995 ; Product number : UV0006 -PDF -ENG ) Set in August 1995 , enables students to assess Berkshire Hathaway's bid for the 49.6% of GEICO Corporation that it does not already own. Students perform a simple valuation of GEICO shares and consider the reasonableness of the 26% acquisition premium.

There are no obvious synergies, and Berkshire Hathaway has announced that it will run GEICO with no changes. Student analysis can include the investment philosophy and remarkable record of Berkshire's CEO, Warren E. Buffett. Description (Carol Brewer’s Investments ; Product number: 204017 -PDF -ENG ) Following h er husband's death in 1994, Carol Brewer took over the management of her family's investments. This case describes the decisions Brewer made during this process, including her choice to seek active account management, her selection of an investment firm, a nd her determination of asset allocation within her portfolio. In 2003, Brewer is reassessing her previous investment choices and considering changes she might need to make in the future in light of her plans to retire in six years and live on the income f rom her investments. Learning objective (1) Techni cal skills for active investments (The following is not necessary for passive investmen t) (1-1) Determine and compare the e xpected returns and required returns , and then determine if the asset is undervalued or overvalued. Notice: the case, “ GMO -Value versus Growth Dilemma,” already covered this part. But, the case (Warren Buffett) will rei nforce this skill with sensitive analysis. (1-2) Determine Intrinsic values – and then determine if the asset is undervalued or overvalued by co mparing with market p rices . (2) Understanding passive versus active investment philosophy (3) Establishing the statement of your “own” investment philosophy 2 1. Some of required basics to conduct case analysis < Dividend Discount Model (DDM) as a specific form of discounted cash flow valuation method > (0)= 1 1+ + 2 (1+ )2+ + 3 (1+ )3+ ⋯ + + (1+ ) Where D t and P t are the divided per share and stock price at t , respectively . The “r” is the discount rate (re quired return). < “Back -Of-Envelope” Method To Expected Return > STEP 1 : With average earnings growth rate forecast tenth year earnings 10 = × (1 + ℎ )10 . STE P 2 : Use the expected P/E in year 10 to estimate the market value of equity in year 10. 10 = ( )× 10 STEP 3 : Calculate the annualized CGY for 10 year holding period. Annualized CGY for 10 -year holding = ( 10 ) 110 − 1 STEP 4 : Calculate the annualized total yield for 10 year holding period (call it the “long - term e xpected return”). Long -term expected return= Annualized CGY for 10 -year holding + Dividend yield 3 < The Factors that increase the return on invested capital > Price premium via competitive advantage Cost and capital efficiency  Innovative products: Di fficult to copy or patented products, services or technologies  Quality  Brand  Customer lock -in  Innovative business method  Unique resources: Advantage resulting from inherent geological characteristics or unique access to raw materials  Economies of scal e  Scalable product/process < Re turn on Inve sted Capital > (1− ) = Net Operating Income After Taxes = EBIT – Taxes (EBIT = “Operating income” or earnings before interests and taxes. = EBT + Interests - Taxes ( )= (1− ) = [ − ℎ− ]+ OR = + − ℎ Notice For GEICO, sum up “Cash” and “Accrued investment income” to determine Excess cash. See Appendix. 4 2. Directions  Read the case thoroughly.  There are directions in each question . Strictly follow them.  When reporting the case analysis, clearly specify which numb er of question you are answeri ng to.  Due date : Jul y 11 th (Tuesday)  Subm it a hard copy in class and a soft cop y on Canvas  Max poi nts with op tional questions = 240 points.  Max poi nts with out d oing op tional questions = 200 points. 3. Questions for case analysis (1) Determining over -/under -valuation via interpreting market’s reaction [ Before the acquisition announce ment, the stock price of Geico was $55.75. The acquisition price was $70. The number of shares of Geico that Warren Buffett had already have in his firm was 34.25 million; and by acquisition Geico was about to become a part of Berkshire Hathaway (BH), mean ing the market value of Geico’s 67.9 million shares outstanding was going to be added into BH’s market value . The case shows on page 1 that the market value of BH went up by $718 million on the acquisition announcement. ] With the facts describe in [ ], we want to determine whether the market thought that Geico’s stock had been undervalued before announcement or not , i.e., the intrinsic value (at the time of announcement) that market thought was greater than the before -announcement price of $55.75 or not . Purpose : Developing the ability to interpret and quantify the reactions by the market. Direction : You have to use the market reaction (a rise by the amount of $718 million) to back out the intrinsic value from the facts in [ ]. Do  What was the intrinsic value if Geico’s stock that the market thought of? Use the following 5 equation to determine the intrinsic value “P.” Also Do  state why the equation makes sense to determine the intrinsic value from the market’s reaction. $718 = 34 .25 × ($70 − 55 .75 )+ 67 .9 × ( − $70 ) Also Do  by comparing the interpreted intrinsic value “P” with the before - announcement price of $55.75, determine whether Geico’s stock had been undervalued or overvalued. Also Do  by comparing the inte rpreted intrinsic value “P” with the acquisi tion price of $70, determine whether Warren Buffet was over paying premium or not. (2) Determining over -/under -valuation via past IRR compared with opportunity cost It is well known that Warrant Buffett detects unrev ealed potentials of investments. If the latent potentials are realized and publicly known, then the value of assets go up. In other words, he has a talent to find out undervalued investments. One possibility why he thought Geico had been undervalued is his experience with investments in Geico stock he had made from 1976. He had purchased 34.25 million shares for $45.7 million. (This implies the per share price was about $1.334 in 1976). Let’s simplify the situation assuming there was one time purchase of 34 .25 million shares for $ 1.334 per share in 1976 and no purchases until the acquisition that occurred in 1995. With the 34.25 million share purchase, he got dividend income stream as shown in Exhibit 8. Assume that Geico’s 1994 year -end market price was $51 .25 (See Appendix). Purpose: Developing the ability to determine under -/over -valuation by comparing estimates of past IRR and required return (or opportunity cost) . Direction Do  Determine the annualized internal rate of return using the data in Exhibit 8 and the initial buy cost and the end price. And, d etermine and report the annual capital gain yield and dividend yield , respectively . Recall chapter 7. Also Do  Answer: based on the realized IRR from this past investment in Geico, was Geico adequately c onsidered undervalued before acquisition? To answer this question, compare the IRR with the required return on the Geico’s equity as given on page 9. Also Do  Answer: Warren Buffett does not believe in the required return via the CAPM. Since he said he tried to meet a 15% return on any investments (see page 9), use this value as the opportunity cost in his mind. Then, by comparing the IRR and this opportunity cost, was Geico well considered undervalued? (3) Determining over -/under -valuation via using “Valu e Line” information The case provides the information of Value Line’s forecasts of Geico dividends and price . See Table 1. 6 Purpose: Developing the ability to determine under -/over -valuation by comparing market price and estimates of intrinsic value Direct ion The discount rate of Geico’s stock was given in the case. In this case, the discount rate was fixed. Do  Use the concept of dividend discount model (DDM) to determine the intrinsic value (for this, you will have the lower estimate of intrinsic value a nd the higher estimate of intrinsic value.) Also do  Answer: do you think the before -announcement Geico sto ck was considered undervalued ? (4) Determining over -/under -valuation via using “Value Line” information The case provides the information of Value Lin e’s forecasts of Geico dividends and price . See Table 1. Purpose: Developing the ability to determine under -/over -valuation by comparing estimates of future IRR and required return Direction Do  use the data in Table 1 and the before -announcement price of $55.75 as the potential buy cost (under no premium) to determine the ann ual IRR for each of high and low ends of range, respectively. Also do  Answer: based on the estimated future IRR, was Geico adequately considered undervalued before acquisition? You r answer should be separate for each of high and low ends of range, respectively. Try to u nderstand why to use the before -announcement price instead of the bid price ($70) for this . It is because the purpose now is to determine whether the stock was underv alued or not by comparing with the required return. --- Now , we want to determine whether the bid price of $70 is an overpayment o r not. If it was an over payment, then the net present value from the acquisition is theoretically negative . Or, equivalently, if that was an overpayment, then the IRR with the bid price ($70) as the buy cost will be lower than the required return (11 % ). Do  Use the data in Table 1 and the bid price of $70 as the buy cost ( which included the premium) to determine the cost -embedde d ann ual IRR for each of high and low ends of range, respectively. Also do  Answer: based on the estimated cost -embedded IRR, determine whether Warren Buffett was overpaying for the acquisition of Geico or not. Your answer should be separate for each of h igh and low ends of range, respectively. (5) Determining over -/under -valuation via using the Dividend Discount Model We want to use the pure two -stage DDM to determine the intrinsic value instead of using the Value Line’s forecasts. The case provides the inf ormation about past dividend payment in Exhibit 8. Purpose: Developing the ability to determine under -/over -valuation by comparing market price and estimates of intrinsic value 7 Direction Do  First d etermine annual dividend growth rates using the data in E xhibit 8 . Then, determine the average annual dividend growth rates using only the last 5 years (with the end year 1994) . And then use the value as the annual growth rate of dividend to forecast future dividends till 2005. The terminal year is 2005. Since then, the long -term growth rate is assumed to be 5.4%. Caution: t he appendix shows that the annual dividend for year 1995 was actually $1.08 per share. Hence, use $1.08 for year 1995 and recursively forecast until 2005. For example the forecasted dividend f or year 1996 is (1+ ℎ )× $1 .08 . And the dividend for year 1997 is (1+ ℎ )2× $1 .08 . Use the two stage DDM to determine the intrinsic value. The estimation of intrinsic value is as of the end of 1995. Caution: do not include the dividend of year 1995 in the intrinsic valuation. Also do  Answer: do you think the before - announcement Geico stock was considered undervalued? (6) Determining over -/under -valuation via using the Dividend Discount Model We want to use the pure two -stage DDM to deter mine the future IRR. The case provides the information about past dividend payment in Exhibit 8. Purpose: Developing the ability to determine under -/over -valuation by comparing estimates of future IRR (via dividend stream ) and required return Direction : Use the forecasts of div idend you constructed for the question (5). Do  Use the before -announcement price of $55.75 as the potential buy cost (under no premium) to determine the ann ual IRR. Caution: the estimation of IRR is as of the end of 1995. Hence, do not include the divide nd of year 1995 in the determination of IRR. Also do  Answer: do you think the before -announcement Geico stock was considered undervalued? You have to compare the IRR with the required return. (7) Determining over -/under -valuation via the “Back -of -Envelope Method to Expected Return ” The Geico ’s earnings per share (EPS) for year 1995 is shown in the Appendix. W ith the stock price of the year end, the P/E ratio in 1995 was around 19. Assume that the P /E ratio of 19 will remain until 2 005 (for 10 -year holding period ). Assume that the growth rate of EP S is equal to the average g rowth rat e of dividend s that estimated for qu esti on (5) . Purpose: Developing the ability to determine under -/over -valuation by comparing estimates of future IRR (via the Back -of -Envelope Method ) and requi red return Direction : Do  First, determ ine the EPS for year 10 (year 2005) [STEP 1]. And then do the [STEPS 2 and 3 ] as shown in this guide . And t hen for [S TEP 4] use the dividend yield that you found for q uestion (2) and determine the total yield (IRR ). Also Do  Answer: based on the Back -of -En velope IRR , was Geico considered undervalued before acquisition? 8 Also Do  Answer: Warren Buffett does not believe in the required return via the CAPM. Since he said he tried to meet a 15% return on any investments (see page 9), use this value as the opportunity cost in his mind. Then, by comparing the IRR and this opportunity cost, was Geico well considered undervalued? (8) Summarize the investment philosophy of Warren Buffett and Carol Brewer (via her Asset Manager) in terms of asset selection (value versus growth), asset allocation, portfolio management, and so on. Do they h ave any common investment philosophy? o Limit answer into a full one page with single space . [Optional Questions – Max Extra Points: 30] (9) Determine the Geico ’s return on invested capital for year 1995 ? Recall that the historical median ROIC of US companies ha s been 10% ~ 1 3% with the recent value of 13% ? (See the Lecture note for chapter 13). o Limit your answer into less than a half page. (10) What potentials of competitive advantages and cost efficiency did Geico have? Do you think the potentials could improve t he ROIC of Geico and make it stable over time? Did Geico have any characteris tics tha t Warre n Buffett liked? W hat were they? o Limit answer into less than one page with single space . (11) In the perfectly efficient market, the expected returns are always equal to the required returns, and hence there are no undervalued or overvalued assets.

If we stron gly believe this, then what is the typical steps/investment philosophy for investment decisions? (Recall what you learned especially from chapter 1, 6 and 7) Direction o Limit answer into a full one page with single space . o Must i nclude the terms such as mark et efficiency, asset allocation, return - risk tradeoff, holding period, diversification, market portfolio (and/or index funds, index ETFs), CML, risk -free assets (and/or money market funds) , expected returns, required returns, risk, and so on.). (12) In the im perfectly efficient market, the expected returns are not always equal to the required returns, and hence there can be undervalued or overvalued 9 assets. If that always bothers you, then what is the typical steps/investment philosophy for investment decisions ? (Recall what you learned especially from chapter 1, 4, 6, 7 and 13) Direction o Limit answer into no less than one page with single space. o Must i nclude the terms such as expected returns, required returns, risk, undervaluation, overvaluation, alpha, style, size ( small, large), valuation (value, growth), holding period, and so on.) (13) Imagine that you r group is an incorporated , professional asset management company. What is the statement of investment philosophy of your company? Direction o Limit the statement into ful l one page with single space. [Optional Question – Max Extra Points: 10 ] (14) Summarize the supporting facts for your investment philosophy that you learned into no less than 90 bullet points. Single space. Below are some examples.  Over the long term, stocks have historically outperformed all other investments.  Ri sky assets generally pay more than safe assets.  The stock market is semi -strong form efficient.  Value stocks historically outperformed growth stocks on average.  …. 10 Appendix GEICO’S Financial Statements For Year 1995 https://www.sec.gov/Archives/edgar/data/277795/0000277795 -96 -000001.txt Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. The following table shows the quarterly high and low prices for the Common Stock, as published in the tabulation of New York Stock Exchange Composite Transactions. The table shows dividends paid to shareholders of record in each quarter of 199 5 and 1994. Dividends 1995 High Low Paid Fourth quarter 70 68 1/4 $ .27 Third quarter 68 7/8 54 1/2 .27 Second quarter 59 3/8 49 1/2 .27 First quarter 51 1/8 47 5/8 .27 Dividends 1994 High Low Paid Fourth quarter 51 1/4 49 $ .25 Third quarter 51 1/2 47 5/8 .25 Second quarter 57 5/8 49 5/8 .25 First quarter 57 1/2 51 1/8 .25 11 GEICO CORPORATION CONSOLIDATED BALANCE SHEETS December 31, in thousands of dollars 1995 1994 ASSETS Investments: Fixed maturities available for sale, at market U.S. Treasury securities and obligations of U.S. government corporat ions and agencies (amortized cost $922,574 and $873,440) $ 955,230 $ 842,086 Obligations of states and political subdivisions (amortized cost $2,513,537 and $2,343,200) 2,592,202 2,292,622 Corporate bonds and notes (amortized cost $89,040 and $105,523) 91,759 97,554 Redeemable preferred stocks (amortized cost $41,257 and $41,259) 41,570 37,863 3,680,761 3,270,125 Equity securities available for sale, at market Common stocks (cost $477,462 and $534,370) 954,813 759,791 Nonredeemable preferred stocks (cost $15,975 and $22,591) 16,248 22,917 971,061 782,708 Short -term investments 341,325 50,033 Total Investments 4,993,147 4,102,866 Cash 50,339 27,580 Accrued investment income 69,974 67,255 Amounts receivable from sales of securities - 2,022 Premiums receivable 280,018 238,653 Reinsurance receivables 125,660 127,189 Prepaid reinsurance premiums 7,988 10,361 Deferred policy acquisition costs 73,984 72,359 Loans receivable, net 11,339 59,448 Federal income taxes - 98,975 Property and equipment, at cost less accumulated depreciation of $120,638 and $113,612 146,317 141,741 Other assets 36,739 49,656 Total Assets $5,795,505 $4,998,105 1995 1994 12 LIABILITIES Policy liabilities: Property and casual ty loss reserves $1,872,037 $1,704,718 Loss adjustment expense reserves 340,008 307,606 Unearned premiums 813,726 747,342 Life benefit reserves and policyholders' funds 112,970 101,298 3,138,741 2,860,964 Debt 434,444 391,378 Amounts payable on purchases of securities 1,518 8,408 Federal income taxes 49,409 - Other liabilities 302,945 291,414 Total Liabilities 3,927,057 3,552,164 SHAREHOLDERS' EQUITY Common Stock - $1 par value, 150,000,000 shares authorized, 71,680,609 and 71,565,359 shares issued and 67,534,733 and 68,291,463 shares outstanding 71,681 71,565 Paid -in surplus 176,058 169,084 Unrealized appreciation of investments 389,722 91,167 Retained earnings 1,505,419 1,330,022 Treasury Stock, at cost (4,145,876 and 3,273,896 shares) (212,816) (167,115) Unearned Empl oyee Stock Ownership Plan shares (61,616) (48,782) Total Shareholders' Equity 1,868,448 1,445,941 Total Liabilities and Shareholders' Equity$5,795,505$4,998,105 13 CONSOLIDATED STATEMENTS OF INCOME For the year ended December 31, in thousands of dollars except per share results 1995 1994 1993 REVENUE Premiums $2,787,011$2,476,276 $2,283,488 Net investment income 226,804 201,790 201,851 Realized gains on investments 21,587 12,898 120,584 Interest on loans receivable 3,704 10,347 11,519 Other revenue 14,909 14,698 20,858 Total Revenue 3,054,015 2,716,009 2,638,300 BENEFITS AND EXPENSES Losses and loss adjustment expenses 2,244,398 1,996,518 1,821,783 Life benefits and interest on policyholders' funds 9,798 8,573 13,521 Policy acquisition expenses 213,081 200,044 197,545 Other operating expenses 244,074 231,984 213,555 Impact o f premium refunds - - (6,699) Interest expense 34,365 27,696 19,975 Total Benefits and Expenses 2,745,716 2,464,815 2,259,680 Net Income Befo re Income Taxes 308,299 251,194 378,620 Federal income tax expense 60,675 42,379 92,193 Net income before cumulative effect of changes in accounting principles 247,624 208,815 286,427 Cumulative effect of cha nges in accounting principles: Postemployment benefits, net of tax - (1,051) - Income taxes - - (8,814) Postretirement benefits, net of tax - - (3,935) Net Income $ 247,624$ 207,764 $ 273,678 EARNINGS PER SHARE Net income before cumulative effect of changes in accounting principles $3.66 $2.98 $4.01 Cumulative effect of changes in accounting principles - (.01) (.18) Net Income $3.66 $2.97 $3.83