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It is well known that many acquisitions fail to deliver the future value anticipated at the time the deals are announced. There can be any number of reasons for M&A failures, but two key ones likely pertain to:
- Practical limitations of popular valuation methodologies. For example, while Discounted Cash Flow (DCF) valuation is straightforward in theory, it can be extremely difficult to apply, given the inherent difficulties of forecasting. Similarly, a valuation based on comparables analysis could be distorted if the businesses used for comparison have been significantly overpriced.
- Inadequate due diligence. Frequently, due diligence is divorced from the valuation process, which often results in its being conducted simply to "get the deal done."
In striking contrast to the problematic M&A track record of many firms, financier Warren Buffett, the Chairman and CEO of Berkshire Hathaway, has been a remarkably successful acquirer. There can be many reasons for this contrast, but a key one is likely Buffett's effective approach to valuation and pricing; in other words, Buffett generally does not overpay for acquisitions[1] . As a student, Buffett received training in valuation at Columbia University from the late Benjamin Graham and has practiced and developed Graham's techniques ever since.
This case shows the potential for utilizing the modern Graham and Dodd (G&D) valuation approach in a corporate setting to improve the odds of successful M&A. G&D valuation differs from other methodologies in that it addresses valuation through a unique construct, the value continuum. This continuum not only focuses on assets and earnings, but also on competitive advantage and growth. By evaluating these elements within an overall framework the G&D method frequently produces more insightful valuations than other methods. Furthermore, those valuations can be proactively utilized to effectively guide due diligence.
To illustrate how modern G&D methodology works in practice, it is applied retrospectively to Berkshire Hathaway's 1995 acquisition of GEICO.
How GEICO twice strayed from its core strategy
In 1936, Leo and Lillian Goodwin founded the Government Employees Insurance Company (GEICO). From the outset GEICO differentiated itself from other insurance companies through its low cost product offerings, which it sold direct to targeted customers rather than through traditional insurance agent channels. Additionally, GEICO chose to insure relatively "safe" drivers such as federal employees...