Geoff Gannon Investor Questions Podcast #6: How Do You Calculate an Insurance Company's Intrinsic Value?

Let’s look at what Warren Buffett said about buying GEICO. Buffett bought GEICO 3 times in his life. In 1951 - he bought some shares of GEICO for himself. In the early 1970s he bought 33% of GEICO for Berkshire Hathaway (BRK.B, Financial). And then in 1995 - he bought the rest of GEICO for $2.3 billion.

I’ll read you what Buffett wrote in his 1995 letter to shareholders:

“…GEICO’s method of selling - direct marketing - gave it an enormous cost advantage over competitors that sold through agents, a form of distribution so ingrained in the business of these insurers that it was impossible for them to give it up.”

[i][/i]Buffett makes a good point. The advantage GEICO had wasn’t just that it could sell directly to customers. It was that GEICO’s competitors couldn’t copy that method because they had to keep their agents happy.

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Maybe you’ve heard people talk about economies of scale and diseconomies of scale. The idea is that some things scale up well while others don’t. A retail store scales up well because some of the costs are the same regardless of how big the store is. You need at least one person to unload trucks and stock shelves. And you need one person at the cash register. If you’re already paying two people every hour - why not have them sell as much as they possibly can?

Other things don’t scale up well. For instance - customer service will get worse as the store sells more stuff. The whole point of selling more stuff was to make good use of the time those 2 employees spent in the store.

But the busier the 2 employees get - the less helpful they‘ll be outside of their basic tasks. Lines at the checkout counter will get longer. And a thousand other bad things will start happening.

So bigger isn’t always better. It’s usually better in some ways and worse in others. The same is true of experience.

Just as there are economies of scale and diseconomies of scale - there are economies of experience and diseconomies of experience.

Practice doesn’t make perfect. Practice makes permanent. And once a company goes down one path - it has a harder time reversing course than someone just starting out in the business.

Insurance companies that use agents have a harder time going direct to customers than insurance companies that never had agents. It’s part of their culture. It’s a tradition some people will fight for - because their jobs depend on it.

GEICO didn’t have to fight the same uphill battle it’s competitors did. Other insurers who wanted to sell directly to customers had to fight with their company’s agents before they could even make their pitch to customers.

And - as Buffett said - selling through agents is a lot more expensive than selling directly to customers. It might make sense to sell some kinds of insurance through agents. But not car insurance. It’s against the law to drive a car without insurance in most states. So car insurance isn’t a hard sell. And it isn’t a special product. It’s something just about everybody needs.

Selling car insurance directly to drivers makes the most sense - because it’s the cheapest way to do it.

Since the question mentioned GEICO - I think we should pick the public company that’s most like GEICO. And that’s Progressive (PGR).

Progressive - like GEICO - does a lot of TV advertising. In fact the company does so much adverting you might just recognize the name “Flo”. And if you don’t recognize her name - I’m sure you’d recognize her face. She’s the helpful lady who uses her price gun to sell car insurance.

It doesn’t matter if you remember seeing Flo on TV or not. What matters is that both Progressive and GEICO spend a lot of money on TV ads.

There’s a good reason for that. GEICO and Progressive sell directly to customers. That means they can price their policies below other insurers and still make a profit.

Insurance companies have 2 kinds of costs. They have losses. And they have expenses. Losses are what the insurer has to pay out to policyholders. Losses make up most of a car insurance company’s total costs.

The other cost is expenses. Expenses include everything an insurer pays for other than losses. And while losses are going to be pretty much the same from one insurer to the next - expenses don’t have to be.

Progressive and GEICO both found - when it comes to car insurance - advertising is less expensive than not advertising. Both companies have grown around 10% a year for the last 10 years without raising their expenses as a percentage of premiums.

In other word: the TV ads have paid for themselves. GEICO and Progressive have been able to spread their other costs over a bigger number of customers thanks to those ads. The result for both companies is that they don’t spend any more in total expenses per dollar of premiums on than they did 10 years ago - when they were both much smaller.

So it isn’t like Progressive and GEICO are losing money today so they can grow bigger tomorrow. They aren’t sacrificing much by spending all this money on TV ads. Because while they’re spending more on advertising - their total expenses per dollar of premiums aren’t higher than they were a decade ago.

And they’re both making profits year in and year out. Even before you count their investment income - Progressive and GEICO have earned money in 9 of the last 10 years. The only really bad year was 2000. That’s when they lost between 4 and 5 cents per dollar of premiums. Investment income can make up some of that. But you can’t run a really profitable car insurance company when you write at a combined ratio of 104 or 105.

An insurer’s combined ratio is just the flipside of its underwriting margin. You hear about profit margins - and operating margins - in all kinds of businesses. Well insurers have margins too. They have something called an underwriting margin - which is the difference between 100 and their combined ratio.

Some insurers don’t have wide underwriting margins. They don’t have to. They can make money by investing float. Car insurance companies aren’t like that.

They make a lot of their money from a solid underwriting margin. Progressive and GEICO both have good underwriting margins.

So that’s where we’ll start our intrinsic value estimate for Progressive - with the underwriting margin.

Which years should we use to come up with an average - or normal - underwriting margin for Progressive?

Let’s keep things simple and just go with the last 10 years. Progressive’s 10 year average underwriting margin is 8.2%.

The company now writes about $14 billion in premiums. Their 5 year average is also about 14 billion. Progressive is writing more and more direct business. But its agency business isn’t growing. So the company hasn’t grown as fast as GEICO in the last few years.

Still - 14 billion looks like a normal premium number. Progressive has repeated that performance in each of the last few years. So 14 billion in premiums is a good starting point for our intrinsic value estimate.

Progressive says it always wants to have an underwriting margin of at least 4%. And except for 2000 - the smallest margin Progressive had in the last 10 years was 5.1%. So the company’s goal of staying above 4% at all times seems realistic. Obviously there will be a few nasty surprises. But over time Progressive should be able to keep its average underwriting margin at 4% or better.

At this point I’d look at GEICO’s numbers again to make sure I’m not making any crazy assumptions. GEICO’s margins have looked a lot like Progressive’s in most years.

GEICO’s underwriting margins are a little lower - more like 6% than 8% - but GEICO is growing faster. And GEICO’s average underwriting margin is safely above the 4% Progressive says is the lowest underwriting margin it will accept.

So that 4% number is a good place to start. If we multiply Progressive’s $14 billion in premiums by its lowest acceptable underwriting margin of 4% - we get $560 million. Progressive has 671 million shares outstanding. So that works out to be 83 cents a share.

We’ll call that 83 cents a share Progressive’s minimum normal underwriting profit. It’s a pretax number. So we should only multiply it by 10 to get the intrinsic value of that earnings stream. Multiplying a pre-tax number by 10 is like multiplying an after-tax number by 15.38 assuming a 35% tax rate. In other words: I’m taking Progressive’s minimum acceptable underwriting profit on its current premium volume and giving that a P/E ratio around 15.

Now if that’s all Progressive did - the stock would be worth $8.33 a share. But we have to remember 2 things:

1) We used a 4% underwriting margin when Progressive’s 10-year average underwriting margin was 8.2%

2) We haven’t given Progressive any credit for its investments.

Up to this point - we’ve totally ignored the fact that Progressive - as an insurance company - owns lots of bonds and some stocks that either pay interest or grow in value over time.

What should we do about that?

There are 2 ways to value an insurance company like Progressive.

Remember when I talked about Berkshire Hathaway. I said Buffett judges Berkshire’s intrinsic value by looking at two yardsticks - or buckets of value. The two buckets are pre-tax earnings per share and investments per share.

To get an intrinsic value estimate we need to take the stuff in one of those two buckets and change it into something that can be compared to what’s in the other bucket.

Since I said underwriting was the most important part of Progressive’s business - I think we should stick with earnings instead of focusing on assets.

So we are not going to give Progressive credit for its investments by adding their price to our intrinsic value estimate. Instead we’re going to take the income those investments throw off in normal years and add that to pre-tax earnings.

Progressive’s average investment income for the last 3 years was $608.5 million.

Is that a number we can trust to continue in the future?

I don’t know. I would need to take a closer look at the company’s investments and how it manages them.

Instead of doing that - I’m going to try to figure out just how low Progressive’s “normal” investment income could possibly get.

I started by taking Progressive’s total investments. Then I threw out all of the company’s federal, state, and local government bonds.

Let me be clear. Those bonds make up a big part of Progressive’s total investments. I took them out because I’m trying to come up with the worst case imaginable. What if interest rates stay near zero for years and years to come?

In that case: Progressive would earn little on these low risk investments. But it would still have some corporate bonds and stocks.

Right now triple A corporate bonds yield 5.22%. Since the civil war the average yield on triple A corporate bonds has been more like 5.5%. So we shouldn’t worry about that 5.22% number being too high. It’s actually a little on the low side.

Now if we multiply Progressive’s investments - excluding all of the government debt it owns - by 5.22% we get $411 million a year in investment income.

I’d say that’s just about the worst case imaginable in terms of any sort of normal investment income for Progressive. Interest rates are already low - yet the company has averaged more than $600 million a year in investment income over the last 3 years.

Again - I want to stress that I think this estimate is too low. Progressive will probably earn a lot more than $411 million a year from its investments. But let’s start with that number.

A 4% underwriting margin on $14 billion in premiums would give Progressive a $560 million underwriting profit. And a 5.22% yield on its non-government debt combined with a 0% yield on everything else would give Progressive another $411 million in investment income.

That means our lowest normal pre-tax earnings estimate for Progressive is $971 million - or about $1.45 a share. Multiply that pre-tax number by 10 and you get $14.50 a share.

That’s the least Progressive could be worth.

Now - of course - I don’t mean that literally. The company could do terrible things. It could start pricing its policies so it lost hundreds of millions of dollars a year.

But there’s no reason to think that’ll happen. We can’t include unrealistic assumptions in our intrinsic value estimate. We need to stick to a reasonable range of possible outcomes. Assuming Progressive will suddenly write at combined ratios above 100 when it has only done that in 1 of the last 10 years is not reasonable.

Let’s move on. $14.50 a share will be our base case. It’s the floor we’ll be working from.

I think there’s a very good chance Progressive’s stock is worth more than $14.50 a share. But we want a true intrinsic value estimate. That means picking a number that is as likely to be too high as it is too low.

And $14.50 a share is nowhere near that number.

How should we change our assumptions to get a true intrinsic value estimate?

I’d do 2 things. First I’d use Progressive’s actual 10 year average underwriting margin - which is 8.2%.

I would then multiply that 8.2% margin by the 14 billion dollars in premiums Progressive now writes. That would put Progressive’s normal underwriting profit at $1.148 billion.

I would then take the company’s average investment income for the last 3 years - which is $608.5 million - and add that to the underwriting profit.

That brings our estimate for Progressive’s normal pre-tax earnings up to $1.757 billion. Divide that by the number of shares outstanding and you get $2.62 a share. Again - that’s a pre-tax number - so you want to multiply it by 10.

When you do that you get $26.20 a share. That’s probably as good an intrinsic value estimate for Progressive as you’re going to get.

But wait. Is it really that simple?

No. Deciding whether or not to buy the stock is not simple. You have to look at the company and its culture. You have to think about the business and the industry. You have to do a lot of things I didn’t talk about.

You need to do all that stuff to have faith in your estimates.

All I’ve done is some basic number crunching.

We made a lot of assumptions. And it’s always good to be clear about what those assumptions are. It’s also a good idea to double check your assumptions by using a couple different methods to value the same stock.

One method I like to use is comprehensive income. Ben Graham was a fan of this approach too. He would add up the changes to the balance sheet over 5 or 7 or 10 years and compare it to net income. He didn’t want to go by net earnings number alone. He wanted to use all the changes that showed up on the balance sheet.

That’s basically what comprehensive income is. It’s an important number for an insurance company.

Let’s look at Progressive’s comprehensive income for the last 5 to 7 years. Progressive’s average comprehensive income for the last 7 years was $1.227 billion. That’s about $1.83 a share on the current share count. Comprehensive income is an after tax number. So I’m going to multiply it by 15 instead of 10.

That gives us $27.73 a share. Which is a good number. I like it because it includes 2008. Progressive had a comprehensive loss of $614.7 million in 2008. I don’t think the company will repeat that anytime soon. Yet even when we include a terrible year like 2008 - we still get an intrinsic value estimate of $27.73 a share.

Using two totally different methods we got intrinsic value estimates of $27.73 a share and $26.20 a share. I think those are good estimates.

They’re the best we can do in 20 minutes. And - to be honest - even if we talked about Progressive for 20 hours or 20 days we’d probably end up with an intrinsic value estimate around 26 to 28 dollars a share.

The top of the intrinsic value range for Progressive has to be $35 a share. I say $35 a share because Progressive’s average comprehensive return on equity for the last 10 years was 21.1% and triple A corporate bonds now yield 5.22%. Divide 21.1% by 5.22% and you get 4.04. Multiply that by Progressive’s per share book value of $8.55 and you get $34.56 a share.

What does all that mean?

Basically I’m saying that Progressive is a growing company. And growing companies usually grow slower in the future than they did in the past. A 21.1% comprehensive return on equity is great. But we have to assume it won’t get better. If you divide 21.1% by today’s 5.22% yield on triple A corporate bonds you get a number just over 4. That’s the highest price-to-book ratio Progressive should trade at. Even a business that earns 20% on equity isn’t worth more than 4 times book value.

So the top of our range has to be $35 a share. I think the bottom - if we’re sticking to realistic numbers - is around $15 a share. That’s what Progressive would be worth if it wrote the same premiums it does now but with a 4% underwriting margin instead of the 8.2% underwriting margin it’s averaged in the past.

So where does that leave us?

Progressive is probably worth about $25 a share. And there’s a very good chance the stock’s intrinsic value is somewhere between $15 and $35 a share.

Okay. But should you buy the stock?

That’s a question for another day. For now: my advice is to think about what I said in past episodes. Notice how Progressive buys back a lot of its own stock. That’s going to have a big affect on the stock price over time.

You need to think about that. And about the company’s future. How much like the past will Progressive’s future really be? And will the company’s underwriting margin stay the same?

If it does - Progressive’s stock will definitely be worth more than the $17 a share it trades at today.

Well that’s all for today’s show. If you have an investing question you want answered call 1-800-604-1929 and leave us a voice mail. That’s 1-800-604-1929.

Thanks for listening.