What might account for the share price increase for Berkshire Hathaway at the announcement?
Review of Warren Buffet’s historical investment success might explain the increase in share price for Berkshire Hathaway at the announcement. Given that he has had a good track record, it is expected that shareholders respond positively. In 1977, the price of Berkshire Hathaway was $89 closing at $25,400 by 1995, an unparalleled annual growth of 37.7%. In comparison, the growth rate of the S&P 500 over the same period was 14.3%. Warren Buffet’s formidable investment performance was also demonstrated when Berkshire Hathaway acquired Scott & Fetzer. Berkshire Hathaway paid $315 million for Scott & Fetzer in 1985 after which they received significant dividends. Again, Buffet’s investment performance on the acquisition of Scott & Fetzer outperformed the S&P 500 evident by an internal rate of return (IRR) of 26.4% including the 1994 cash flow or 14.9% without 1994 cash flow on the Scott & Fetzer investment.
Clearly, Warren Buffet’s positive investment performance carried a significant weight and influences the market to have a more optimistic outlook on his investments. Conversely, his historical records of investment success do add value to shareholders trust.
Was the bid price appropriate?
GEICO Corp was selling for $55.75 at the time Warren Buffet and Berkshire Hathaway made an offer of $70 including a 26% premium over the current GEICO stock price. One would expect that what appeared to be an overprice bid would lead to a negative market reaction. On the contrary, Berkshire Hathaway’s shares closed up 2.4% for the day for a gain in market value of $718 million after the announcement. The gain’s effect was twofold – it increased the value of GEICO shares (34.25 million) Berkshire Hathaway already owned and it also made the $70 offer to purchase the remaining shares of GEICO appear beneficial to Berkshire Hathaway. Berkshire Hathaway made a gain of $488 million due to shares they already owned. In addition, the remaining increase in value of $73.39 for Berkshire Hathaway represented added value given that the company would pay only $70 per share. Given the market reaction, it appeared that Berkshire’s shareholders were in agreement of Warren Buffet’s offer and that the $70 bid was not unreasonable.
Furthermore, the Value Line projections can be used to validate the appropriateness of Warren Buffet’s offer. The valuation of any security is the present value of expected cash flow. For stocks, the expected cash flows are dividends and the projected future sales price. Based on footnote 32, the risk-adjusted discount rate for the cash flows from GEICO stock was estimated to be 11%. Using the risk adjusted discount rate to discount the Value Line projections, GEICO’s stock price is assessed to be at $58.32 under the low projections and $79.85 under the high projections which makes the offer price of $70 to be inline with Value Line projection.
Agency Theory
Agency theory is the theory of the relationship between principals (shareholders) and agents (managers), and that there is a potential conflict of interest between principals and agent if their goals are not aligned. In the case of Berkshire Hathaway, there appears to be no conflict of interest between principals (shareholders) and agents (Warren Buffet as the manager) since Warren Buffet as Berkshire Hathaway’ manager has a personal interest in the company, therefore, is trusted by shareholders to act in their best interest as he would for himself and ensures that the company continues to grow and maintain profitability.
