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Two Issues I found in the paper were: Risk and discount rates and Diversification principles of

Buffett.
Risk and discount rates: Theoretically and Psychologically as risk increases one expects
higher returns, but Buffett doesnt seems agreeing with this fact. He argues that there is
no risk if you understand what are you doing and thus he values the assets at risk free rate
i.e. 30 year treasury bonds. But having the complete understanding of characteristics of
underlying asset is not possible, there is always lack of information regarding the asset
performance and hence risk is attached with the asset which should be compensated by
higher discount rate.

Diversification: Buffett disagrees with the idea of elimination of unsystematic risk by


diversification of portfolio. He believes that investors should identify businesses they
understand and concentrate on them. But again the proposition of not having full
knowledge about the asset makes this claim fading away, and in this instance for an
investor this risk can be eliminated by diversification.

Was $70 paid to GEICO shareholders justified ?


Present share price is considered as the present value of all future cashflows and cashflows
related to a share is dividend.
Forecasted dividends in coming years to be paid are as follows :

Low case represents: 7.2% increase in dividends YoY


High case represents: 14.4% increase in dividends YoY
Now Buffett considers himself to be aware of all risks related to investments thus he doesnt
consider extra risk premium over risk free rate. He discounts cashflows at risk free rate of 6.86%
to derive the current share price.
On discounting at 6.86% we receive share price as follows:
Low case: $70
High case: $96.09
But doesnt considering the risk involved in equity and believing that all risks are uncontrolled,
lowers the discount rate and overestimates the value.
Adding up the equity risk premium of 5.5% over the risk free rate, provides us with the required
return of 11% (using CAPM). Discounting cashflows at 11% , shareprice estimated are as
follows:
Low case: $58.31 (which is 4.4% above the current shareprice of $55.75 )
High case: $79.85
Conclusion
Proposing 26% premium for the share doesnt justifies me, at the times when companys stock is
hammered by inflation, high accidental rates and high damage awards. Shares of GEICO might
be brought at a premium of 4-10%, which would have made better off both GEICO shareholders
and Buffett.