What's Geico Really Worth to Berkshire Hathaway?

Warren Buffett often refers to Berkshire Hathaway's (BRK.A 0.50%) (BRK.B 0.48%) book value as a measuring stick for its success or failure, but even he admits it has its flaws. 

One of the biggest is that Berkshire's losing acquisitions have to be marked down, but winners can't be marked up. Therefore, Berkshire's book value captures many of its failures, but none of its biggest acquisition successes.

Few success stories are as important as Geico, which has grown by leaps and bounds since Berkshire acquired it 1996. But as Buffett wrote in his 2010 letter to shareholders, Geico has never been written up to reflect its success and is carried at a mere $1.4 billion premium 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 2010 letter to shareholders to estimate its value.

Valuing Geico the Buffett way

Geico is a highly profitable insurance company that's truly in a league of its own. Any buyer would pay far more than liquidation value to own it, given its extraordinary underwriting record and growing earnings power. 

In his 2010 letter, Buffett shed some light on how he thought about the effective price of $4.6 billion Berkshire Hathaway paid for the company in 1996. He wrote that it valued Geico's intangibles at 97% of annual premium volume at the time of acquisition.

Using the same methodology today, Geico should be worth about $29.3 billion more than book value, based on premiums earned in the most recent quarter. That values its brand and customers at roughly 20 times the $1.4 billion figure reported on the balance sheet.

Is that too high? Possibly. Consider that Geico had far more growth ahead of it in 1996 than it does today. Autonomous cars weren't even a thought 20 years ago, but now we think about when cars might drive themselves and how much we'll save on insurance when they do. 

Furthermore, Berkshire could afford to pay a premium for the portion of Geico it didn't own in 1996, as making it a control company eliminated a layer of taxation on the dividends Geico paid to Berkshire. There are many reasons to believe the historical multiple is too high to use today. 

But before we conclude that valuing Geico's intangibles at 97% of earned premiums is wholly unrealistic, we should subject it to a sanity test. We can use Buffett's method to value a comparable insurance company, Progressive Insurance (PGR -0.05%), and see if the resulting valuation is too high or low.

Image source: Matt Koppenheffer, The Motley Fool.

Progressive is a well-run insurance company that generates most of its premiums and profit from car insurance, just like Geico. What Progressive lacks in expense control (roughly half of its business is driven by costly agents) it makes up for with low loss ratios. Geico and Progressive have been wildly profitable compared to peers, and both are growing premiums at a respectable double-digit clip. 

Interestingly, Progressive has a current market cap of approximately $31.8 billion, which is eerily close to the valuation you get when you use Buffett's method to determine its fair value.

Data source: SEC filings. Calculations by author.

That Progressive's current market capitalization is only about $2 billion (7%) lower than the valuation Buffett's method would ascribe to it suggests that applying a high multiple to the value of customer relationships, branding, and other intangible assets isn't completely unreasonable for a high-quality insurance company. 

The $52 billion gecko

Berkshire Hathaway doesn't break out its insurance companies' balance sheets in its financial statements, but based on regulatory disclosures, we can get close to Geico's true value. Geico and its affiliates had a regulatory surplus (equity) of $23 billion at the end of 2016. Adding on $29.3 billion of value for Geico's brand and customer relationships calculated under the Buffett method, Geico could be worth $52.3 billion in all.

The hidden value of Geico's brand and customer relationships go a long way to explain why Buffett believes that Berkshire Hathaway is an attractive investment even at prices above book value. Buffett has said he'd happily repurchase shares of Berkshire at 1.2 times book value, and in the past he has done just that. 

Last quarter, Berkshire's book value stood at $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 truly worth $27.9 billion more than its carrying value ($29.3 billion valuation per Buffett's method, minus $1.4 billion of intangibles already reflected on Berkshire's balance sheet), it makes up nearly half the $62.4 billion difference between Berkshire's book value and Buffett's estimate of his conglomerate's intrinsic value.

It's quite clear that Geico's intangibles, its gecko included, are a very important piece of the Berkshire pie.