This post is a brief excerpt from Joseph Calandro, Jr.’s upcoming presentation at the NYSSA on ‘ Graham and Dodd and Keys to Modern Financial Analysis’
The history of Warren Buffett is closely linked with Geico. Mr. Buffett was first exposed to Geico by his professor in graduate school, the late Benjamin Graham, and he has been fascinated with the company ever since. As a student of Graham’s, he even visited the company’s headquarters and became immediately “hooked” on the firm. For example, Mr. Buffett successfully invested in Geico during the 1950s and he continued to follow the firm through its troubles in the 1970s. Eventually, he took it private in 1995 and ever since Geico’s performance and growth have been absolutely stellar. Therefore, it serves as a classic modern value investment that has, appropriately, generated much research and commentary by analysts and scholars alike.
In my book, Applied Value Investing, I approached the valuation of Geico using the modern Graham and Dodd (G&D) approach to illustrate its 4 levels of value. The purpose of breaking down the 4 levels of value is to show how a valuation emerges from the safest source of value, the balance sheet or NAV, to the progressively riskier sources of earnings power value, franchise value and lastly, growth value. This approach contrasts with traditional DCF where estimates of value rely solely on projections of future performance. Whereas both methods acknowledge future uncertainty, G&D valuation builds up the analysis in such a way that the estimates stem from the balance sheet and earnings power of the firm, making for a more conservative and structured valuation.
By first evaluating Geico’s balance sheet and then its income statement, I was able to estimate the NAV and EPV of the firm and identify the presence of a potential franchise. Once the franchise was identified, the next step was to analyze its competitive characteristics and sustainability. This analysis is briefly profiled in a recent paper I wrote in the Journal of Private Equity titled “Growth Based Franchise Opportunities: Lessons from the Geico Acquisition.” In short, I identified the strategic, financial, operational, and managerial characteristics that produced Geico’s low-cost-based franchise. I was then confident enough to move to the next level of value, Growth.
The growth value I derived was significantly above Buffett’s purchase price and therefore effectively validated the acquisition from a G&D standpoint as that price contained a Margin of Safety. This valuation contrasts favourably with other case studies that rely on DCF to value Geico as those valuations do not result in both a definitive purchase price and margin of safety.
In an upcoming presentation at the New York Society of Security Analysts, I will be profiling the Geico acquisition from both a traditional valuation and modern G&D perspective. The objective of the presentation is to practically demonstrate the utility of modern G&D valuation, and to show how it can be used to mitigate the risk of common valuation errors. The errors reviewed in the presentation were identified and developed by a leading academic financial scholar.
My findings and analyses are applicable to a broad range of parties, including financial analysts, fund managers, private investors and, particularly, M&A specialists. While many investors have appropriately followed Mr. Buffett into the G&D school, relatively few M&A specialists use G&D valuation. I do not know why this is the case, especially if you compare Mr. Buffett’s M&A track record to the general deal track record. Whatever the reason(s), given the current state of the economy, all deal makers will likely be under intense pressure to do value creating deals. If so, the G&D approach offers a time-tested approach that can be practically leveraged to achieve that goal.
Joseph Calandro, Jr., is the author of Applied Value Investing (NY: McGraw-Hill, 2009). Chris Goulakos, an MBA candidate contributed to this posting. More of Joseph’s writings can be found at the following link.