Stock price valuation/analysis Case Study 2: Warren E. Buffett, 1995

Case Study 2: Warren E. Buffett, 1995

This case was prepared by Professor Robert F. Bruner as the basis for
classroom discussion rather than to illustrate effective or ineffective
handling of an administrative situation.

On August 25, 1995, Warren Buffett, the CEO of Berkshire Hathaway,
announced that his firm would acquire the 49.6 percent of GEICO
Corporation that it did not already own. The $2.3 billion deal would
give GEICO shareholders $70.00 per share, up from the $55.75 per share
market price before the announcement. Observers were astonished at the
26 percent premium that Berkshire Hathaway would pay, particularly since
Buffett proposed to change nothing about GEICO, and there were no
apparent synergies in the combination of the two firms. At the
announcement, Berkshire Hathaway’s shares closed up 2.4 percent for
the day, for a gain in market value of $718 million.1 That day, the
Standard & Poor’s 500 index closed up 0.5 percent.

The acquisition of GEICO renewed public interest in its architect,
Warren Buffett. In many ways he was an anomaly. One of the richest
individuals in the world (with an estimated net worth of about $7
billion), he was also respected and even beloved. Though he had
accumulated perhaps the best investment record in history (a compound
annual increase in wealth of 28 percent from 1965 to 1994),2 Berkshire
Hathaway paid him only $100,000 per year to serve as its CEO. Buffett
and other insiders controlled 47.9 percent of the company, yet Buffett
ran the company in the interests of all shareholders. He was the subject
of numerous laudatory articles and three biographies,3 yet he remained
an intensely private individual. Though acclaimed by many as an
intellectual genius, he shunned the company of intellectuals and
preferred to affect the manner of a down-home Nebraskan (he lived in
Omaha), and a tough-minded investor. In contrast to other investment
‘stars,’ Buffett acknowledged his investment failures quickly and
publicly. Though he held an MBA from Columbia University and credited
his mentor, Professor Benjamin Graham, with developing the philosophy of
value-based investing that guided Buffett to his success, he chided
business schools for the irrelevance of their theories of finance and
investing.

Numerous writers sought to distill the essence of Buffett’s success.
What were the key principles that guided Buffett? Could these be applied
broadly in the late 1990s and into the 21st century, or were they unique
to Buffett and his time? From an understanding of these principles,
analysts hoped to illuminate Berkshire Hathaway’s acquisition of
GEICO. Under what assumptions would this acquisition make sense? What
were Buffett’s probable motives in the acquisition? Would the
acquisition of GEICO prove to be a success? How would it compare to the
firm’s other recent investments in Salomon Brothers, USAir, and
Champion International?

Berkshire Hathaway, Inc.

The company was incorporated in 1889 as Berkshire Cotton Manufacturing,
and eventually grew to become one of New England’s biggest textile
producers, accounting for 25 percent of the country’s cotton textile
production. In 1955, Berkshire merged with Hathaway Manufacturing and
began a secular decline due to inflation, technological change, and
intensifying competition from foreign competitors. In 1965 Buffett and
some partners acquired control of Berkshire Hathaway, believing that the
decline could be reversed. Over the next 20 years it became apparent
that large capital investments would be required to remain competitive
and that even then the financial returns would be mediocre. In 1985,
Berkshire Hathaway exited the textile business. Fortunately, the textile
group generated enough cash in the initial years to permit the firm to
purchase two insurance companies headquartered in Omaha: National
Indemnity Company and National Fire & Marine Insurance Company.
Acquisitions of other businesses followed in the 1970s and 1980s.

The investment performance of a share in Berkshire Hathaway had
astonished most observers. In 1977 the firm’s year-end closing share
price was $89. On August 25, 1995, the firm’s closing share price was
$25,400. In comparison, the annual average total return on all large
stocks from 1977 to the end of 1994 was 14.3 percent.4 Over the same
period, the Standard & Poor’s 500 index grew from 107 to 560. Some
observers called for Buffett to split the firm’s share price, to make
it more accessible to the individual investor. He steadfastly refused.

In 1994, Berkshire Hathaway described itself as ‘a holding company
owning subsidiaries engaged in a number of diverse business
activities.’5 Exhibit 1 gives a summary of revenues, operating
profits, capital expenditures, depreciation, and assets for the various
segments. By 1994, Berkshire’s portfolio of businesses included the
following:

Figure 1: Share Price of Berkshire Hathaway versus SIP 500 Index

• Insurance Group. The largest component of Berkshire’s portfolio
focused on property and casualty insurance, on both a direct and a
reinsurance basis. The investment portfolios of the Insurance Group
included meaningful equity interests in 10 other publicly traded
companies. The equity interests are summarized in Exhibit 2, along with
Berkshire’s share of undistributed operating earnings in these
companies. Because the earnings in some of these companies could not be
consolidated with Berkshire’s under generally accepted accounting
principles (GAAP), Buffett published Berkshire’s ‘lookthrough’
earnings6—as shown in Exhibit 2, the share of undistributed earnings
of major investees accounted for 40–50 percent of Berkshire’s total
‘look-through’ earnings. Exhibit 3 summarizes investments in
convertible preferred7 stocks that Berkshire Hathaway had made in recent
years, serving as a ‘white squire’ to major corporations—each of
these firms had been the target of actual or rumored takeover attempts.

• Buffalo News. A daily and Sunday newspaper in upstate New York.

• Fechheimer A manufacturer and distributor of uniforms.

• Kirby. A manufacturer and marketer of home cleaning systems and
accessories.

• Nebraska Furniture. A retailer of home furnishings.

• See’s Candies. A manufacturer and distributor of boxed chocolates
and other confectionery products.

• Childcraft and World Book. A publisher and distributor of
encyclopedias and related educational and instructional materials.

• Campbell Hausfeld. A manufacturer and distributor of air
compressors, air tools, and painting systems.

• H.H. Brown Shoe Company; Lowell Shoe, Inc.; and Dexter Shoe Company.
Companies involved in the manufacture, import, and distribution of
footwear.

In addition to these businesses, Berkshire owned an assortment of
smaller businesses8 generating about $400 million in revenues.

Berkshire Hathaway’s Acquisition Policy

The GEICO announcement renewed general interest in Buffett’s approach
to acquisitions. Exhibit 4 gives the formal statement of acquisition
criteria contained in Berkshire Hathaway’s 1994 annual report. In
general, the policy expressed a tightly disciplined strategy that
refused to reward others for actions that Berkshire Hathaway might just
as easily take on its own. Therefore, analysts scrutinized the criteria
to assess where they might offer winning ideas to Buffett.

One prominent example to which Buffett referred was Berkshire
Hathaway’s investment in Scott & Fetzer in 1986. The managers of Scott
& Fetzer had attempted a leveraged buyout of the company in the face of
rumored hostile takeover attempt. When the Labor Department objected to
the company’s use of an employee stock ownership plan to assist in the
financing, the deal fell apart. Soon the company attracted unsolicited
proposals to purchase the company, including one from Ivan F. Boesky,
the arbitrageur. Buffett offered to buy the company for $315 million
(which compared to its book value of $172.6 million). Following the
acquisition, Scott & Fetzer paid Berkshire Hathaway dividends of $125
million, even though it earned only $40.3 million that year. In
addition, Scott & Fetzer was conservatively financed, going from modest
debt at the acquisition to virtually no debt by 1994. Exhibit 5 gives
the earnings and dividends for Scott & Fetzer from 1986 to 1994. Buffett
noted that in terms of return on book value of equity, Scott & Fetzer
would have easily beaten the Fortune 500 firms.9 The annual average
total return on large company stocks from 1986 to 1994 was 12.6
percent.10

Buffett’s Investment Philosophy

Warren Buffett was first exposed to formal training in investing at
Columbia University, where he studied under Professor Benjamin Graham.
The coauthor of a classic text, Security Analysis, Graham developed a
method of identifying undervalued stocks (i.e., stocks whose price was
less than ‘intrinsic value’). This became the cornerstone of the
modern approach of ‘value investing.’ Graham’s approach was to
focus on the value of assets such as cash, net working capital, and
physical assets. Eventually, Buffett modified that approach to focus
also on valuable franchises that were not recognized by the market.

Over the years, Buffett had expounded his philosophy of investing in his
CEO’s letter to shareholders in Berkshire Hathaway’s annual report.
By 1995, these lengthy letters had accumulated a broad following because
of their wisdom and their humorous, self-deprecating tone. The letters
emphasized the following elements:

1 Economic reality, not accounting reality. Financial statements
prepared by accountants conformed to rules that might not adequately
represent the economic reality of a business. Buffett wrote:

Because of the limitations of conventional accounting, consolidated
reported earnings may reveal relatively little about our true economic
performance. Charlie and I, both as owners and managers, virtually
ignore such consolidated numbers ... Accounting consequences do not
influence our operating or capital-allocation process.11

Accounting reality was conservative, backward-looking, and governed by
generally accepted accounting principles (GAAP). Investment decisions,
on the other hand, should be based on the economic reality of a
business. In economic reality, intangible assets such as patents,
trademarks, special managerial know-how, and reputation might be very
valuable, yet under GAAP they would be carried at little or no value.
GAAP measured results in terms of net profit; in economic reality, the
results of a business were its flows of cash.

A key feature of Buffett’s approach defined economic reality at the
level of the business itself, not the market, the economy, or the
security—he was a fundamental analyst of a business. His analysis
sought to judge the simplicity of the business, the consistency of its
operating history, the attractiveness of its long-term prospects, the
quality of management, and the firm’s capacity to create value.

2 The cost of the lost opportunity. Buffett compared an investment
opportunity against the next best alternative, the so-called lost
opportunity. In his business decisions, he demonstrated a tendency to
frame his choices as ‘either/or’ decisions rather than ‘yes/no’
decisions. Thus, an important standard of comparison in testing the
attractiveness of an acquisition was the potential rate of return from
investing in common stocks of other companies. Buffett held that were
was no fundamental difference between buying a business outright and
buying a few shares of that business in the equity market. Thus, for
him, the comparison of an investment against other returns available in
the market was an important benchmark of performance.

3 Value creation: time is money. Buffett assessed intrinsic value as the
present value of future expected performance.

[All other methods fall short in determining whether] an investor is
indeed buying something for what it is worth and is therefore truly
operating on the principle of obtaining value for his investments ...
Irrespective of whether a business grows or doesn’t, displays
volatility or smoothness in earnings, or carries a high price or low in
relation to its current earnings and book value, the investment shown by
the discounted-flows-of-cash calculation to be the cheapest is the one
that the investor should purchase.12

Enlarging on his discussion of ‘intrinsic value,’ Buffett used an
educational example:

We define intrinsic value as the discounted value of the cash that can
be taken out of a business during its remaining life. Anyone calculating
intrinsic value necessarily comes up with a highly subjective figure
that will change both as estimates of future cash flows are revised and
as interest rates move. Despite its fuzziness, however, intrinsic value
is all-important and is the only logical way to evaluate the relative
attractiveness of investments and businesses.

To see how historical input (book value) and future output (intrinsic
value) can diverge, let’s look at another form of investment, a
college education. Think of the education’s cost as its ‘book
value.’ If it is to be accurate, the cost should include the earnings
that were foregone by the student because he chose college rather than a
job. For this exercise, we will ignore the important non-economic
benefits of an education and focus strictly on its economic value.
First, we must estimate the earnings that the graduate will receive over
his lifetime and subtract from that figure an estimate of what he would
have earned had he lacked his education. That gives us an excess
earnings figure, which must then be discounted, at an appropriate
interest rate, back to graduation day. The dollar result equals the
intrinsic economic value of the education. Some graduates will find that
the book value of their education exceeds its intrinsic value, which
means that whoever paid for the education didn’t get his money’s
worth. In other cases, the intrinsic value of an education will far
exceed its book value, a result that proves capital was wisely deployed.
In all cases, what is clear is that book value is meaningless as an
indicator of intrinsic value.13

To illustrate the mechanics of this example, consider the hypothetical
case presented in Exhibit 6. Suppose an individual has the opportunity
to invest $50 million in a business—this is its ‘cost’ or ‘book
value.’ This business will throw off cash at the rate of 20 percent of
its investment base each year. Suppose that instead of receiving any
dividends, the owner decides to reinvest all cash flow back into the
business—at this rate the book value of the business will grow at 20
percent per year. Suppose that the investor plans to sell the business
for its book value at the end of the fifth year. Does this investment
create value for the individual? One determines this by discounting the
future cash flows to the present at a cost of equity of 15
percent—suppose that this is the investor’s opportunity cost, the
required return that could have been earned elsewhere at comparable
risk. Dividing the present value of future cash flows (i.e., Buffett’s
‘intrinsic value’) by the cost of the investment (i.e., Buffett’s
‘book value’) indicates that every dollar invested buys securities
worth $1.23. Value is created.

Consider an opposing case, summarized in Exhibit 7. The example is
similar in all respects except for one key difference: the annual return
on the investment is 10 percent. The result is that every dollar
invested buys securities worth $0.80. Value is destroyed.

Comparing the two cases in Exhibits 6 and 7, the difference in value
creation and destruction is driven entirely by the relationship between
the expected returns and the discount rate: in the first case, the
spread is positive; in the second case, it is negative. Only in the
instance where expected returns equal the discount rate will book value
equal intrinsic value. In short, book value or the investment outlay may
not reflect economic reality: One needs to focus on the prospective
rates of return, and how they compare to the required rate of return.

4 Measure performance by gain in intrinsic value, not accounting profit.
Buffett wrote:

Our long-term economic goal ... is to maximize the average annual rate
of gain in intrinsic business value on a per-share basis. We do not
measure the economic significance or performance of Berkshire by its
size; we measure by per-share progress.14

The gain in intrinsic value could be modeled as the value added by a
business above and beyond a charge for the use of capital in that
business. The gain in intrinsic value was analogous to ‘economic
profit’ and ‘market value added,’ measures used by analysts in
leading corporations to assess financial performance. Those measures
focus on the ability to earn returns in excess of the cost of capital.

5 Risk and discount rates. Conventional academic and practitioner
thinking held that the more risk one took, the more one should get paid.
Thus, discount rates used in determining intrinsic values should be
determined by the risk of the cash flows being valued. The conventional
model for estimating discount rates was the capital asset pricing model
(CAPM), which added a risk premium to the long-term risk-free rate of
return (such as the U.S. Treasury bond yield).

Buffett departed from conventional thinking, by using the rate of
return on the long-term (e.g., 30-year) U.S. Treasury bond to discount
cash flows.15 Defending this practice, Buffett argued that he avoided
risk, and therefore should use a ‘risk-free’ discount rate. His firm
used almost no debt financing. He focused on companies with predictable
and stable earnings. He or his vice chairman, Charlie Munger, sat on the
boards of directors where they obtained a candid, inside view of the
company and could intervene in decisions of management if necessary.
Buffett wrote:

I put a heavy weight on certainty. If you do that, the whole idea of a
risk factor doesn’t make sense to me. Risk comes from not knowing what
you’re doing.16

We define risk, using dictionary terms, as ‘the possibility of loss or
injury.’ Academics, however, like to define ‘risk’ differently,
averring that it is the relative volatility of a stock or a portfolio of
stocks—that is, the volatility as compared to that of a large universe
of stocks. Employing data bases and statistical skills, these academics
compute with precision the ‘beta’ of a stock—its relative
volatility in the past—and then build arcane investment and capital
allocation theories around this calculation. In their hunger for a
single statistic to measure risk, however, they forget a fundamental
principle: It is better to be approximately right than precisely
wrong.17

6 Diversification. Buffett disagreed with conventional wisdom that
investors should hold a broad portfolio of stocks in order to shed
company-specific risk In his view, investors typically purchased far too
many stocks rather than waiting for the one exceptional company. Buffet
said.

Figure businesses out that you understand and concentrate.
Diversification is protection against ignorance, but if you don’t feel
ignorant, the need for it goes down drastically.18

7 Investing behavior should be driven by information, analysis, and
self-discipline, not by emotion or ‘hunch.’ Buffett repeatedly
emphasized ‘awareness’ and information as the foundation for
investing. He said, ‘Anyone not aware of the fool in the market
probably is the fool in the market.’19 Buffett was fond of repeating a
parable told him by Benjamin Graham:

There was a small private business and one of the owners was a man named
Market. Every day Mr. Market had a new opinion of what the business was
worth, and at that price stood ready to buy your interest or sell you
his. As excitable as he was opinionated, Mr. Market presented a constant
distraction to his fellow owners. ‘What does he know?’ they would
wonder, as he bid them an extraordinarily high price or a depressingly
low one. Actually, the gentleman knew little or nothing. You may be
happy to sell out to him when he quotes you a ridiculously high price,
and equally happy to buy from him when his price is low. But the rest of
the time you will be wiser to form your own ideas of the value of your
holdings, based on full reports from the company about its operations
and financial position.20

Buffett used this allegory to illustrate the irrationality of stock
prices as compared to true intrinsic value. Graham believed that an
investor’s worst enemy was not the stock market, but oneself. Superior
training could not compensate for the absence of the requisite
temperament for investing. Over the long term, stock prices should have
a strong relationship with the economic progress of the business. But
daily market quotations were heavily influenced by momentary greed or
fear and were an unreliable measure of intrinsic value. Buffett said,

As far as I am concerned the stock market doesn’t exist. It is there
only as a reference to see if anybody is offering to do anything
foolish. When we invest in stocks, we invest in businesses. You simply
have to behave according to what is rational rather than according to
what is fashionable.21

Accordingly, Buffett did not try to ‘time the market’ (i.e., trade
stocks based on expectations of changes in the market cycle)—his was a
strategy of patient, long-term investing. As if in contrast to ‘Mr.
Market,’ Buffett expressed more contrarian goals: ‘We simply attempt
to be fearful when others are greedy and to be greedy only when others
are fearful.’22 Buffett also said, ‘Lethargy bordering on sloth
remains the cornerstone of our investment style,’23 and, ‘The
market, like the Lord, helps those who help themselves. But unlike the
Lord the market does not forgive those who know not what they do.’24

Buffett scorned the academic theory of capital market efficiency. The
efficient markets hypothesis (EMH) held that publicly known information
was rapidly impounded into share prices, and that as a result, stock
prices were ‘fair’ in reflecting what was known about a company.
Under EMH, there were no bargains to be had and trying to outperform the
market would be futile. ‘It has been helpful to me to have tens of
thousands turned out of business schools taught that it didn’t do any
good to think,’ Buffett said.25

I think it’s fascinating how the ruling orthodoxy can cause a lot of
people to think the earth is flat. Investing in a market where people
believe in efficiency is like playing bridge with someone who’s been
told it doesn’t do any good to look at the cards.26

8 Alignment of agents and owners. Explaining his significant ownership
interest in Berkshire Hathaway, Buffett said, ‘I am a better
businessman because I am an investor. And I am a better investor because
I am a businessman.’27

As if to illustrate this sentiment, he said,

A managerial ‘wish list’ will not be filled at shareholder expense.
We will not diversify by purchasing entire businesses at control prices
that ignore long-term economic consequences to our shareholders. We will
only do with your money what we would do with our own, weighing fully
the values you can obtain by diversifying your own portfolios through
direct purchases in the stock market.28

For four of Berkshire’s six directors, over 50 percent of their
family net worth was represented by shares in Berkshire Hathaway. The
senior managers of Berkshire Hathaway subsidiaries held shares in the
company, or were compensated under incentive plans that imitated the
potential returns from an equity interest in their business unit, or
both.

GEICO Corporation

Berkshire Hathaway began purchasing shares in GEICO in 1976, and by 1980
had accumulated a 33 percent interest (34.25 million shares) for $45.7
million. During the period from 1976 to 1980, GEICO’s share price had
been hammered by double-digit inflation, higher accident rates, and high
damage awards that raised the costs of its business more rapidly than
premiums could be increased. By August 1995, that stake had grown to
50.4 percent of the firm’s shares (because GEICO had repurchased some
of its own shares while Berkshire had maintained its holdings) and the
original stake of $45.7 million had grown in value to $1.9 billion.29
Also, GEICO had paid an increasing dividend each year (see Exhibit 8).
From 1976 to 1994, the average annual total return on large company
stocks was 13.5 percent.30

In explaining the decision to acquire the rest of the shares in GEICO,
Buffett noted:

• The firm was the seventh largest auto insurer in the United States,
underwriting policies for 3.7 million cars.

• The firm’s senior managers were ‘extraordinary’ and had an
investment style similar to Buffett’s. These managers would add depth
to Berkshire Hathaway’s senior management bench and provide continuity
in case anything happened to Buffett (age 65) or Munger (age 72).

• The firm was the lowest-cost insurance provider in the industry.

Some analysts sought to test the suitability of Buffett’s $70 per
share offer for GEICO using the discounted cash flow approach. On July
7, 1995, Value Line published a forecast of GEICO’s dividends31 and
future stock price within a range of possible outcomes:

Table 1: Value Line Forecast Information

Forecasted Dividends Low End of Range High End of Range

1996 $1.16 $1.16

1997 $1.25 $1.34

1998 $1.34 $1.55

1999 $1.44 $1.79

2000 $1.55 $2.07

Forecasted stock price in 2000 $90.00 $125.00



Value Line also presented evidence consistent with a cost of equity for
GEICO of 11 percent.32 GEICO had outstanding 67,889,574 shares as of
April 30, 1995.

Analysts noted that the timing of Berkshire Hathaway’s bid followed
closely Walt Disney Company’s bid to buy Capital Cities/ABC for $19
billion. Since some of the proceeds would be in cash, Berkshire
Hathaway would need to reinvest the funds elsewhere.

Conclusion

Conventional thinking held that it would be difficult for Warren Buffett
to maintain his record of 28 percent annual growth in shareholder
wealth. Buffett acknowledged, ‘A fat wallet is the enemy of superior
investment results.’331 He stated that it was the firm’s goal to
meet a 15 percent annual growth rate in intrinsic value. Would the
GEICO acquisition serve the long-term goals of Berkshire Hathaway? Was
the bid price appropriate? What might account for the share price
increase for Berkshire Hathaway at the announcement?

References

1 The change in Berkshire Hathaway’s share price at the date of the
announcement was $609.60. The company had outstanding 1,177,750 shares.

2 Buffett’s initial cost per share in Berkshire Hathaway in 1965 was
about $17.578. On August 25, 1995, the price per share closed at
$25,400.

3 Robert G. Hagstrom, Jr., The Warren Buffett Way (New York: John Wiley
& Sons, 1994); Andrew Kilpatrick, Of Permanent Value: The Story of
Warren Buffett (Birmingham: AKPE, 1994); and Roger Lowenstein, Buffett:
The Making of an American Capitalist (New York: Random House, 1995).

4 Reported in Stocks, Bonds, Bills, and Inflation, 1994 (Chicago:
lbbotson Associates), p. 10.

5 Berkshire Hathaway, Inc., annual report, 1994, p. 6.

6 ‘Look-through’ earnings was calculated as the sum of Berkshire’s
operating earnings reported in its income statement, plus the retained
operating earnings of major investees not reflected in Berkshire’s
profits, less tax on what would be paid by Berkshire if these earnings
had been distributed to Berkshire. (The presentation used a 14 percent
tax rate, the rate Berkshire paid on dividends it received.)

7 Convertible preferred stock is preferred stock that carries the right
to be exchanged by the investor for common stock. The exchange, or
‘conversion,’ right is like a call option on the common stock of the
issuer. The terms of the convertible preferred state the price at which
common shares can be acquired in exchange for the principal value of the
convertible preferred stock.

8 These included companies in conduit fittings, marketing motivational
services, retailing fine jewelry, air compressors, sun and shade control
products, appliance controls, zinc die cast fittings, automotive
compounds, pressure and flow measurement devices, fractional horsepower
motors, boat winches, cutlery, truck bodies, furnace burners, compressed
gas fittings, and molded plastic components.

9 This exempts from the comparison firms emerging from bankruptcy in
recent years. Buffett’s observation was made in Berkshire
Hathaway’s 1994 annual report.

10 Reported in Stocks, Bonds, Bills, and Inflation, 1994.

11 Berkshire Hathaway, Inc., annual report, 1994, p. 2.

12 Berkshire Hathaway, Inc., annual report, 1992, p. 14.

13 Berkshire Hathaway, Inc., annual report, 1994, p. 7.

14 Ibid., p. 2.

15 The yield on the 30-year U.S. Treasury bond on August 25, 1995, was
6.86 percent. The beta of Berkshire Hathaway was 0.95.

16 Quoted in Jim Rasmussen, ‘Buffett Talks Strategy with Students,’
Omaha World-Herald, January 2, 1994, p. 26.

17 Berkshire Hathaway annual report, 1993, and republished in Andrew
Kilpatrick, Of Permanent Value: The Story of Warren Buffett (Birmingham:
AKPE, 1994), p. 574.

18 Quoted in Forbes, October 19, 1993, and republished in Andrew
Kilpatrick, Of Permanent Value: The Story of Warren Buffett, p. 574.

19 Quoted in Michael Lewis, Liar’s Poker (New York: Norton, 1989),
p. 35.

20 Originally published in Berkshire Hathaway, Inc., annual report,
1987. This quotation was paraphrased from James Grant, Minding Mr.
Market (New York: Times Books, 1993), p. xxi.

21 Peter Lynch, One Up on Wall Street (New York: Penguin Books, 1990),
p. 78.

22 Berkshire Hathaway, Inc., annual report, 1986, p. 16.

23 Berkshire Hathaway, Inc., annual report, 1990, p. 15.

24 Berkshire Hathaway, Inc., Letters to Shareholders, 1977–1983, p.
53.

25 Quoted in Kilpatrick, Of Permanent Value, p. 353.

26 Quoted in L.J. Davis, ‘Buffett Takes Stock,’ New York Times,
April 1, 1990, p. 16.

27 Quoted in Forbes, October 19, 1993, and republished in Kilpatrick, Of
Permanent Value, p. 574.

28 ‘Owner-Related Business Principles’ in Berkshire Hathaway, Inc.,
annual report, 1994, p. 3.

29 This assumes the pre-announcement GEICO share price of $55.75.

30 Reported in Stocks, Bonds, Bills, and Inflation, 1994, p. 10.

31 GEICO paid dividends quarterly, though Value Line presented only an
annual forecast. Annual figures are given here for simplicity.

32 Analysts used the capital asset pricing model to estimate GEICO’s
cost of equity. Value Line estimated GEICO’s beta at 0.75. (In
comparison, Berkshire Hathaway’s beta was 0.95.) The equity market
risk premium was about 5.5 percent. And the risk-free rate estimated by
the yield on the 30-year U.S. Treasury bond was 6.86 percent.

33 Quoted in Garth Alexander, ‘Buffett Spends $2bn on Return to His
Roots,’ Times Newspapers Ltd., August 17, 1995.

Exhibit 1: Business Segment Information, Berkshire Hathaway, Inc.
(dollars in millions)

Revenues Pretax operating profit* Capital expenditures Depreciation
Identifiable assets

Segment 1994 1993 1994 1993 1994 1993 1994 1993 1994 1993

Insurance $1,437 $1,591 $639 $961 $0.9 $1.2 $0.9 $0.8 $18,494 $16,127

Candy 216 201 47 40 4.1 4.3 4.1 4.1 69 70

Encyclopedias 191 199 24 19 0.1 0.7 1.4 1.5 76 75

Home-cleaning systems 207 193 44 41 1.0 1.5 4.2 5.3 42 49

Home furnishings 245 209 17 21 22.6 5.3 6.2 2.7 128 101

Newspaper 151 145 54 50 5.2 3.6 2.2 1.9 48 45

Shoes 609 370 76 40 17.9 4.4 10.2 5.2 673 642

Uniforms 151 122 14 13 4.6 1.0 2.5 1.8 95 88

Other 639 568 †(192) 60 10.7 13.0 18.0 17.3 1,712 2,324

Total $3,847 $3,599 $722 $1,246 $67.1 $35.0 $49.6 $40.5 $21,338
$19,520



* Before interest expense.

† Includes pretax charge of $269 representing an other-than-temporary
decline in value of investment in USAir Group, Inc. preferred stock.

N.B. Columns may not sum to the total because of rounding.

Source: Berkshire Hathaway, Inc., annual report, 1994.

Exhibit 2: Major Investees of Berkshire Hathaway, and ‘Look-Through’
Earnings (dollars in millions)

Berkshire’s approximate ownership at year-end Berkshire’s share of
undistributed operating earnings (in millions)

Berkshire’s Major Investees 1994 1993 1994 1993

American Express Co. 5.5% 2.4% $25 $16

Capital Cities/ABC 13.0 13.0 85 83

Coca-Cola 7.8 7.2 116 94

Federal Home Loan Mortgage 6.3 6.8 47 41

Gannett 4.9 — 4 —

GEICO 50.2 48.4 63 76

Gillette 10.8 10.9 51 44

PNC Bank 8.3 — 10 —

Washington Post 15.2 14.8 18 15

Wells Fargo 13.3% 12.2% 73 53

Berkshire’s share of undistributed earnings

$492 $422

Hypothetical tax on these earnings

(68) (59)

Reported operating earnings of Berkshire

606 478

Total ‘look-through’ earnings of Berkshire

$1,030 $841



Source: Berkshire Hathaway, Inc., annual report, 1994, p. 13.

Exhibit 3: Berkshire’s Investments in Private Purchases of
Convertible Preferred Stocks

Dividend Rate Year of Purchase Cost (in millions) Market Value (in
millions, at Dec. 1995)

Champion International Corp.a 9.25% 1989 $300 $388

First Empire State Corp.b 9.00 1991 40 110

The Gillette Companyc 8.75 1989 600 2,502

Salomon Inc.d 9.00 1987 700 728

USAir Group, Inc.e 9.25 1989 358 215



a The Champion International issue could be converted into common
shares at $38.00 per share. At August 25, 1995, Champion
International’s common share price was $57.50. By December 31, 1995,
Champion’s share price had fallen to $42.75.

b The First Empire issue could be converted into common shares at a
conversion price of $78.91 per share. First Empire has the right to
redeem the issue beginning in 1996. At August 25, 1995, First
Empire’s common share price was $184.50.

c The Gillette issue could be converted into common stock at $25.00 per
share, and carried a mandatory redemption by Gillette after 10 years.
In February 1991, following the highly successful introduction of the
Sensor razor, Gillette announced that it would redeem the issue at
$31.75, which effectively forced Berkshire to convert its holding into
common stock. Berkshire converted, and received 12 million common
shares, or 11 percent of Gillette’s total shares outstanding. At
August 25, 1995, Gillette’s share price was $43.00.

d The Salomon issue could be converted into common stock at $38.00 per
share. If Berkshire did not convert the preferred stock, Salomon would
redeem it over five years, beginning October 1995. At August 25, 1995,
Salomon’s common share price was $37.125.

e The USAir issue could be converted into common shares at $60 per
share. If Berkshire did not convert the series into common stock, USAir
would have to redeem the preferred in 10 years. At August 25, 1995, the
USAir common share price was $8.50.

Source: Berkshire Hathaway, annual report, 1995, p. 16.

Exhibit 4: Berkshire Hathaway Acquisition Criteria

We are eager to hear about businesses that meet all of the following
criteria:

1. Large purchases (at least $10 million of after-tax earnings).

2. Demonstrated consistent earning power (future projections are of no
interest to us, nor are ‘turnaround’ situations).

3. Businesses earning good returns on equity while employing little or
no debt.

4. Management in place (we can’t supply it).

5. Simple business (if there’s lots of technology, we won’t
understand it).

6. An offering price (we don’t want to waste our time or that of the
seller by talking, even preliminarily, about a transaction when the
price is unknown).

The larger the company, the greater will be our interest: We would like
to make an acquisition in the $2–$3 billion range.

We will not engage in unfriendly takeovers. We can promise complete
confidentiality and a very fast answer—customarily within five
minutes—as to whether we’re interested. We prefer to buy for cash,
but will consider issuing stock when we receive as much in intrinsic
business value as we give.

Our favourite form of purchase is one fitting the pattern through which
we acquired Nebraska Furniture Mart, Fechheimer’s, Borsheim’s, and
Central States Indemnity. In cases like these, the company’s
owner-managers wish to generate significant amounts of cash, sometimes
for themselves, but often for their families or inactive shareholders.
At the same time, these managers wish to remain significant owners who
continue to run their companies just as they have in the past. We think
we offer a particularly good fit for owners with such objectives and we
invite potential sellers to check us out by contacting people with whom
we have done business in the past.

Charlie and I frequently get approached about acquisitions that don’t
come close to meeting our tests: We’ve found that if you advertise an
interest in buying collies, a lot of people will call hoping to sell you
their cocker spaniels. A line from a country song expresses our feeling
about new ventures, turnarounds, or auction-like sales: ‘When the
phone don’t ring, you’ll know it’s me’.

Besides being interested in the purchase of businesses as described
above, we are also interested in the negotiated purchase of large, but
not controlling, blocks of stock comparable to those we hold in Capital
Cities, Salomon, Gillette, USAir, and Champion. We are not interested,
however, in receiving suggestions about purchases we might make in the
general stock market.

Source: Berkshire Hathaway, Inc., annual report, 1994, p. 21.

Exhibit 5: Scott & Fetzer, Book Value of Equity, Earnings and Dividends,
1986–1994

Beginning Book Value Earnings Dividends Ending Book Value

1986 $172.6 $40.3 $125.0 $87.9

1987 87.9 48.6 41.0 95.5

1988 95.5 58/0 35/0 118..5

1989 118.5 58.5 71.5 105.5

1990 105.5 61.3 33.5 133.3

1991 133.3 61.4 74.0 120.7

1992 120.7 70.5 80.0 111.2

1993 111.2 77.5 98.0 90.7

1994 $90.7 $79.3 $76.0 $94.0



Source: Berkshire Hathaway, Inc., annual report, 1994, p. 7.

Exhibit 6: Hypothetical Example of Value Creation

Assume:

• A five-year investment horizon, when you liquidate at ‘book’ or
accumulated investment value.

• An initial investment of $50 million.

• No dividends paid; all cash flows reinvested.

• ROE = 20%

• Cost of equity = 15%



Year





0 1 2 3 4 5

Investment, or book equity, value 50 60 72 86 104 124

Market value (or ‘intrinsic value’) = PV @ 15% of 124 = $61.65

Market/book = $61.65 / 50.00 = 1.23

Value created: $1.00 invested becomes $1.23 in market value.

Source: Casewriter analysis.

Exhibit 7: Hypothetical Example of Value Destruction

Assume:

• A five-year investment horizon, when you liquidate at ‘book’ or
accumulated investment value.

• An initial investment of $50 million.

• No dividends paid; all cash flows are reinvested.

• ROE = 10%

• Cost of equity = 15%



Year





0 1 2 3 4 5

Investment, or book equity, value 50 55 60 67 73 81

Market value (or ‘intrinsic value’) = PV @ 15% of $81 = $40.30

Market/book = $40.30 / 50.00 = 0.80

Value destroyed: $1.00 invested becomes $0.80 in market value.

Source: Casewriter analysis.

Exhibit 8: GEICO Dividend Payment History (dollars in millions, except
per-share figure)

Year GEICO Dividend Per Share Total Dividends to Berkshire Hathaway*

1976 $0.00 $0.00

1977 0.01 0.34

1978 0.04 1.37

1979 0.07 2.40

1980 0.09 3.08

1981 0.10 3.43

1982 0.11 3.77

1983 0.14 4.80

1984 0.18 6.17

1985 0.20 6.85

1986 0.22 7.54

1987 0.27 9.25

1988 0.33 11.30

1989 0.36 12.33

1990 0.40 13.70

1991 0.46 15.76

1992 0.60 20.55

1993 0.68 23.29

1994 $1.00 $34.25



* Total dividends to Berkshire were estimated by multiplying the per
share dividend times 34.25 million shares, Berkshire’s holdings in
GEICO. This presentation assumes that all of Berkshire’s shares in
GEICO were acquired in 1976.

Source of annual dividends per share: Value Line Investment Survey.

Source: Bruner, R.F., Case Studies in Finance: Managing for Corporate
Value Creation, 3rd edn, Irwin McGraw-Hill, Boston, 1999, pp. 2–17.