Berkshire Hathaway (BRK.B, BRK.A) presents a valuation challenge for the security analyst given its diverse array of operating businesses, equity investments, and insurance operations. This challenge is compounded by the limitations of GAAP accounting in capturing the economic potential of the company.
This paper will disaggregate the various parts of Berkshire Hathaway and value them independently while also discussing any contributions to the conglomerate structure that cannot be captured on a standalone basis. This report will also examine Berkshire through the more conventional earnings and book value approaches.
The author's estimates about future financial performance will be noted but not fully justified due to limited space. Additionally, limited descriptive background will be given to shorten the length of the paper. In short, the author assumes some familiarity of the reader pertaining to the company as well as the industrial economy and accounting concepts.
This paper represents an incomplete and ongoing effort. The author welcomes any comments or questions.
Berkshire's operating businesses report financial results in three segments: (i) Railroads, Utilities & Energy (ii) Manufacturing, Service and Retail and (iii) Finance and Financial Products. In 2011, the combined segments reported after-tax net income of $7.73 billion. (2011 10-K). During the first nine months of 2012, the combined segments reported after-tax net income of $6.63 billion. (2012 3Q 10-Q) The author expects full-year earnings to approximate $9.3 billion.
Railroads, Utilities & Energy:
Burlington Northern Santa Fe
Berkshire acquired BNSF in 2010 in a cash and stock deal that valued the equity at $26.5 billion. Berkshire held 22.5% of BNSF's equity prior to the tender, implying a lower total cost basis.
Rails are advantaged players within the freight industry. This advantage stems from the nearly infinite replacement cost of road, lower diesel consumption per ton mile than trucking, and improving pricing power as legacy contracts expire. Within the railroad sector, BNSF has an advantaged position relative to most of its peers. BNSF's 32,000 miles of road are entirely west of the Mississippi. The West enjoys higher average population growth, access to growing import/export markets with Asia, vast oil shale deposits in North Dakota, and Texas, with insufficient pipeline and refining infrastructure, and less reliance on coal-fired utilities.
These advantages are reflected in BNSF's financial performance. During the first nine months of 2012, BNSF increased reported net income by 18.2% on a year-over-year basis. The author estimates full-year earnings will approximate $3.5 billion versus $2.98 billion in 2011.
While Berkshire doesn't disclose full financial statements for BNSF, additional details can be gleaned from its annual R-1 report filed with the Surface Transportation Board. Importantly, although capital expenditures in 2011 were $1.5 billion greater than depreciation, free cash flow exceeded net income due to BNSF's net increase in deferred income taxes. BNSF's cash tax rate was 10% versus its reported tax rate of 37%. At year-end 2011, BNSF's deferred tax liabilities equaled $15.8 billion. This liability should be maintained or grow as long as BNSF continues to make qualifying purchases of PP&E. The distinction between cash and reported tax rates, and the subsequent deferred tax liability it creates, is important as it amounts to a perpetual loan from the government at a zero cost of capital. As capital is fungible within Berkshire, this "loan" can be invested elsewhere to create shareholder value.
Another important takeaway from the Surface Transportation Board report is the extremely high return on incremental invested capital that BNSF appears to be generating. Invested capital at BNSF increased by $1.92 billion in 2011 and after-tax operating income is on track to increase by just under $600 million in 2012, implying a ROIIC of >30%. The author feels that looking at ROIIC in a discrete time period is prone to be misleading because it is difficult to disaggregate the increased productivity of base capital versus incremental capital. However, while ROIIC may not be a precise measurement, it is likely indicative of increasing returns on aggregate capital. This is partially substantiated by the fact Union Pacific saw its return on invested capital increase from 10.8% in 2010 to 12.4% in 2011.
The large capital outlays that can be deployed into BNSF at a high return represent a de facto ROIC put for a portion of Berkshire's excess capital. To this point, Berkshire will likely spend just under $4 billion in PP&E at BNSF this year with depreciation approximating $1.5 billion. Using UNP's aggregate ROIC of 12.4% as a proxy for BNSF's ROIIC implies after-tax operating income will increase by roughly $310 million next year. The previous calculation appears somewhat conservative given that after-tax operating income is on pace to increase by $600 million off a capital program of $3.2 billion in 2011.
Valuing BNSF is made easier by the existence of a close market comparable in Union Pacific. Union Pacific is also a Western rail with 32,000 miles of road, similar freight composition, and capable management. UNP's reported net income was 10% greater than BNSF's in 2011 but BNSF's free cash flow was 15% higher (BNSF generated higher operating cash flow largely due to a lower cash tax rate and CAPEX was virtually identical). UNP's current market capitalization is $58 billion, which would imply a P/E ratio of 16.5x and 14.8x the author's 2012 and 2013 earnings estimates for BNSF, respectively. While these multiples are fairly higher than the S&P average, they appear justified by BNSF's advantaged position within freight transportation, superior cash generation, elevated returns on capital, and nearly infinite replacement costs.
Berkshire acquired 75% of Mid-American in 1999 for an implied enterprise value of $9 billion. Berkshire's ownership stake is now 89.8% and its share of proportional earnings were $1.2 billion in 2011. The author estimates Berkshire's proportional share of earnings to approximate $1.3 billion in 2012. Mid-American's assets include regulated utilities, interstate natural gas pipelines, and a real estate brokerage.
Mid-American is a less attractive asset than BNSF, exhibited by its mid-single digit EPS growth over the past several years. Additionally, returns on invested capital are significantly lower as seen by their financial filings with applicable regulatory authorities (Mid-American Financial Filings). Invested capital at MA increased by $1.79 billion in 2011, but after-tax operating income, according to the author's estimates, will only increase by $85 million in 2012. This implies a return on incremental invested capital of approximately 5%. The author estimates this return is only slightly higher than MA's cost of debt capital. However, mitigating factors may be at work, which depressed returns on capital this year including: low electricity demand (ii) low natural gas prices and and latency between capital deployment and income generation. Additionally, MA has filed a number of rate cases which, if won, may improve subsequent returns.
For valuation purposes, the author assumes that MA would distribute 75% of net income as dividends and trade in line with utility peers at a 5% yield. This equates to an equity valuation of $20 billion, 15x 2012 earnings, and 1.3x 2011 book value.
Total Value for Railroad, Utilities & Energy
BNSF: $58 billion
Mid-American: $20 billion
Total Value: $78 billion
Total Value per Berkshire Class B Share: $32
Estimated 2012 Earnings: $4.8 billion - 6.1% Earnings Yield
Estimated 2013 Earnings: $5.3 billion - 6.8% Earnings Yield
Total Assets (2011): $117.6 Billion
Estimated 2012 Return on Assets: 4.1%
Total Equity (2011): $58 billion
Estimated 2012 Return on Equity: 8.3%
Manufacturing, Service & Retail
This segment reported net income of $3.0 billion in 2011. The author estimates 2012 and 2013 earnings of $3.9 billion and $4.2 billion, respectively. One should note that a significant portion of this year's increase in earnings is attributable to the first full year of Lubrizol as an operating subsidiary (closed September 2011). (2012 3Q 10-Q)
In examining this sector, the analyst is impeded by a lack of detailed financial disclosure. However, a brief attempt will be made to value the larger businesses and to propose an approximate valuation for the entire segment.
Berkshire acquired Lubrizol for $8.7 billion. Lubrizol has spent an additional $500 million making tuck-in acquisitions. Lubrizol appears to be of higher quality than its chemical peers given fairly predictable demand for lubricants. This is manifested by consistent financial performance over the past several years. (Lubrizol 2010 10-k)
Berkshire no longer breaks out specific earnings attributable to Lubrizol, however, a careful reading of the most recent 10-Q implies that pre-tax income approximated $880 million during the first nine months of 2012. Annualizing this income and applying a tax rate of 35% implies net income of $770 million. This is not particularly impressive given that Lubrizol generated net income of $732 million in 2010 - its last year as a public company. However, Lubrizol likely has significant non-cash amortization charges given its purchase price was $6 billion greater than the then current book value. Assuming these intangible assets are amortized over 15 years, this would equate to annualized non-cash after-tax charges of $260 million against reported GAAP earnings. The author believes this is substantiated by the fact that full-year revenue should approximate $6.2 billion in 2012 versus $5.4 billion in 2010, implying decremental margins (unusual for a chemical company) or that non-cash items are at play.
For valuation purposes the author capitalizes Lubrizol's 2012 earnings at 13x. This is a slight premium to average chemical company P/E ratios of 10-12x but is justified by Lubrizol's less volatile end markets and the author's intuition that cash earnings are higher than GAAP. This equates to an equity value of $10 billion.
Berkshire acquired 64% of Marmon in 2004 for $4.5 billion. Berkshire currently owns 80.8% of the company and will acquire the balance in 2013 or 2014 for a price to be determined by the then current earnings. Marmon operates 11 standalone business lines largely pertaining to flow control, engineered wire & cable, crane services, and equipment leasing.
Marmon's recent financial performance has improved markedly, with pre-tax income increasing 15.5% year-to-date after increasing 22% in 2011. The author estimates full-year pre-tax income of $1.14 billion, equating to net income attributable to Berkshire of $600 million, assuming a 35% tax rate.
For valuation purposes, the author ascribes a 14x multiple to current-year earnings, roughly in-line with its industrial peers and the S&P at large. This equates to an equity value of $8.5 billion.
Berkshire owns dozens of other business that are lumped in this segment and have very limited specific disclosure. These businesses range from farm equipment manufacturing to fractional aircraft leasing. The author expects these businesses to generate approximately $2.5 of net income in 2012. The author arbitrarily assigns a multiple of 12x for an aggregate value of $30 billion while acknowledging that intrinsic value could be substantially higher or lower.
Total Value for Manufacturing, Service & Retail
Lubrizol: $10 billion
Marmon: $8.5 billion
Other Businesses: $30 billion
Total Value: $48.5 billion
Total Value Per Class B Share: $19.50
2012 Estimated Earnings: $3.9 billion - 8% Earnings Yield
2013 Estimated Earnings: $4.2 billion - 8.7% Earnings Yield
Finance & Financial Products
This is Berkshire's smallest operating segment, consisting of equipment leasing and manufactured housing. The division reported net income of $516 million in 2011. The author expects net income of $570 and $650 in 2012 and 2013, respectively. Of note, this segment reported net income of $732 million in 2007, implying substantial leverage to a housing recovery.
The author applies a 12x multiple to current earnings for an aggregate value of $6.8 billion.
Value: $6.8 billion
Value per Class B Share: $3
2012 Earnings: $570 million - 8.4% Earnings Yield
2013 Earnings: $650 million - 9.6% Earnings Yield
Summary of Operating Businesses
The author expects aggregate earnings from Berkshire's operating businesses to approximate $9.3 and $10.2 billion in 2012 and 2013, respectively. The author assigns an aggregate valuation to these businesses of $133 billion, or $54 per class B Share. On a standalone basis, the valuation implies that Berkshire's operating businesses trade in-line with S&P 500 on 2013 earnings. This appears fairly conservative as >50% of earnings will be come from railroads and utilities and the operating businesses have broad exposure to an increase in residential construction.
As the aforementioned earnings estimates include associated interest expense and taxes, their value can be deducted from the current market capitalization to derive the implied value of Berkshire's investment portfolio and insurance operations. This value will be the subject of the next portion of this paper.
At the end of the 3rd quarter, Berkshire's investment portfolio consisted of equity securities with a fair value of $88 billion, fixed maturity securities of $31.9 billion, and hybrid securities of $19.7 billion. (2012 3Q 10-Q)
Fair Value: $88 billion
Using 2013 consensus estimates in conjunction with the most recent 13-F filing, Berkshire's proportional share of equity holdings should generate earnings of $6.9 with $2.3 billion distributed as dividends. 60% of Berkshire's equity portfolio consists of four positions: Coca-Cola (NYSE:KO), Wells Fargo (NYSE:WFC), IBM (NYSE:IBM) and American Express (NYSE:AXP). The author has developed independent financial models for each of these companies as they are large enough to warrant further discussion.
KO: Coca-Cola is the world's most recognized brand. Per capita consumption of Coca-Cola has been increasing virtually since the company's inception. Over 1.6 billion 8 oz. servings of Coke are consumed per day. The author expects 2013 earnings of $2.30 per share on revenue of $50 billion. Berkshire's proportional share of these earnings would approximate $920 million and with associated dividends of $480 million.
WFC: Wells Fargo maintains the dominant deposit franchise in the United States, allowing the company to fund its $1.3 trillion of assets at less than .4%. This franchise will likely appreciate in value when interest rates increase. The author expects 2013 earnings of $3.50 per share. Berkshire's proportional share of these earnings would approximate $1.5 billion with associated dividends of $500 million.
IBM: International Business Machines provides software, hardware and services for a substantial portion of the world's governments and businesses. IBM has filed for more patents than any other corporation for 19 consecutive years. More than 2/3rds of IBM's revenues come from recurring contracts. The author expects 2013 earnings of $16.50 per share. Berkshire's proportional share of these earnings would approximate $1.12 billion with associated dividends of $270 million.
AXP: American Express is the dominant provider of credit cards for businesses and affluent individuals. The author expects 2013 earnings of $5 per share. Berkshire's proportional share of these earnings would approximate $760 million with associated dividends of $150 million.
Hybrid Securities/Other Investments
Fair Value: $19.7 billion
This portfolio consists of preferred stocks with warrant preferences acquired during the financial crisis and as bridge financing. Full terms of these securities can be found in the 10-Q.
Wrigley: $4.4 billion of subordinate notes at 11.75% and $2.1 billion of preferred stock at 5%.
Dow (NYSE:DOW): $3 billion of preferred stock at 8.5%
Bank of America (NYSE:BAC): $5 billion of preferred stock at 6%
This amounts to a total of $14.5 billion with an annual pre-tax investment income of $1.18 billion. Dow has expressed interest in tendering for their preferred stock. Given the current interest rate regime, this tender would likely occur at a significant premium to face value. Berkshire doesn't disclose the current carrying value of specific preferred stocks.
BAC: Option to acquire ~7% of company at $7.14/share, expiring in 2021.
GE (NYSE:GE): Option to acquire ~ 1.3% of company at $22.25/share, expiring in 2013.
Goldman Sachs (NYSE:GS): Option to acquire ~8.5% of company at $115/share, expiring in 2013.
DOW: Option to acquire ~7% of company at varying strike prices and maturities.
In regards to the warrants, only Bank of America is deeply in the money with approximately 9 years left until maturity. As such, these warrants have significant value. The Goldman Sachs warrants are currently slightly in the money while General Electric warrants are slightly out of the money, both with limited time to expiry. The Dow warrants are deeply out of the money.
Fair Value: $31.9 billion
This portfolio consists largely of sovereign debt of the UK, Canada, Australia and the Netherlands as well as undisclosed corporate debt. By deducting the implied investment income generated by equity securities and preferred stocks, the portfolio appears to be generating pre-tax investment income of $1.5 billion, or a 4.7% current yield.
As of their latest 10-Q, Berkshire disclosed total unrealized gains in their investment portfolio of $45.6 billion. These gains have created a significant deferred tax liability. Berkshire does not disclose the specific DTL associated with their securities portfolio, but at a 35% corporate tax rate it would be equivalent to $16 billion. In other words, the cash liquidation value of the portfolio would be $16 billion less than its current carrying value. The author has noticed that several security analysts attribute Berkshire's entire $44.5 billion DTL to their investment portfolio. As discussed previously, the majority of the DTL resides in the operating businesses. BNSF and Mid-American alone have $24 billion of deferred tax liabilities.
The reader should also consider the fact that the DTL associated with the investment portfolio resides as an undiscounted liability on the balance sheet. As long as Berkshire's security gains remain in an unrealized position it does not present a cash obligation. As Berkshire tends to be a long-term holder, the implication is that the NPV of these liabilities is likely far less than the liability stated on their balance sheet. To err conservatively, the author deducts the entire value of the deferred tax liability when calculating the value of the investment portfolio.
Investment Portfolio Valuation:
Current Carrying Value of Securities: $139.5 billion
Associated Deferred Tax Liability: $16 billion
Net Liquidation Value Attributable to Shareholders: $123.5 billion
Value per Class B Share: $50
Cash and Cash Equivalents:
As of their latest 10-Q, Berkshire held cash and cash equivalents of $47.8 billion. $41.8 billion of this was held at insurance subsidiaries. $4.2 billion was held in the railroads and utilities segment, much of which will be swept as a dividend to the holding company at year end. The author estimates free cash flow approximates $13 billion in 2012, implying year-end cash balances of $51 billion.
Berkshire has stated their intention to keep $20 billion in aggregate cash on hand. This cash is needed for working capital purposes, high ratings for the insurance subsidiaries, and to pay potential catastrophe losses. For this reason, the author deducts this amount from cash assets attributable to shareholders as it cannot be distributed or used to purchase assets. However, the author acknowledges that high ratings for the insurance subsidiaries and the "safety premium" associated with Berkshire do create value.
Historically, Berkshire has allocated excess capital efficiently as evidenced by 19.8% compounded book value growth as a public company. (Annual Reports) Hence, a dollar of excess capital held by Berkshire has had a NPV >$1. The case could then be made that Berkshire should be given option value on top of their excess capital. The value of this option should increase when capital can be deployed at attractive rates (market downturns, liquidity crises, etc.). This should create a degree of counter-cyclicality in Berkshire's equity as returns on incremental invested capital likely increase when broader market values decline. Given this option has a nebulous value, the author simply includes current cash net of the $20 billion withholding as an asset attributable to shareholders.
Total YE cash balance: $51 billion
Cash subject to withholding: $20 billion
Cash available for shareholders: $31 billion
Value per Class B Share: $12.50
Insurance Operations/Float Liability:
Berkshire's insurance operations consist of GEICO, GenRe, BH Primary Group, and BH Reinsurance Group. The operations generated $32 billion in earned premiums in 2011 with an after-tax underwriting profit of $154 million. The operations appear to be on track for a 10th consecutive year of underwriting profitability.
The author believes the primary role of Berkshire's insurance operations is to provide low or negative cost capital to fund Berkshire's other investments. This capital comes in the form of float. At the end of the 3rd quarter, Berkshire had float balances of $72 billion. The author views float as a substitute for debt financing with its cost of capital defined as:
((Earned Premium*(1-Combined Ratio))*(1-Tax Rate))/(Average Float Balance*-1)
In years where Berkshire generates breakeven or profitable underwriting results, this capital is free or has a negative cost - they are paid to borrow insured's money. Alternatively, assuming break-even underwriting and perpetual operations, float becomes functionally similar to a zero coupon perpetual bond. A zero coupon perpetual bond has an NPV of zero. By extension, the securities and businesses owned via float financing, assuming breakeven underwriting, have the same NPV to shareholders on a levered or unlevered basis.
This contrasts from the GAAP treatment of float, where Berkshire accounts for the entirety of the $72 billion as a liability. The author believes this is one of the primary reasons why book value is an understated expression of intrinsic value.
For valuation purposes, the author assumes that Berkshire's insurance operations underwrite on a break-even basis and operate in perpetuity. Therefore, the value of the insurance operations and the float liability net to zero. The author believes this is a conservative approach as Berkshire has maintained underwriting profitability throughout most of its history.
Value of Insurance Operations/Float Liability: $0
Holding Company Liabilities:
Holding company liabilities consist of debt, credit default obligations, and equity index option liabilities.
Holding company debt:
Berkshire has $13.4 billion in holding company debt at an average rate of 3.1%. $8 billion of this amount was issued in conjunction with their purchase of BNSF.
Credit Default and Equity Index Options:
Berkshire recognizes a liability of $10.5 billion in connection with credit default and equity index options.
$9.5 billion of this liability pertains to their equity index options. The notional value of the underlying is $34 billion. The options are European style, written against 4 undisclosed indices, and begin to expire in 2018. The intrinsic value of the options was $5.4 billion at the end of the 3rd quarter. If the indices all expired at zero, Berkshire would need to recognize an additional liability of ~$24 billion. Conversely, if the indices rose 20% on average by expiration, Berkshire's cash obligation would be negligible.
Berkshire records a liability against their credit default options of $500 million. The credit default options are written against 500 individual issuances with an aggregate notional value of $6.4 billion. The issues are subject to "sizeable aggregate deductibles," however, no disclosure of the deductibles is provided.
The reader should note that option liabilities are calculated using the Black-Scholes option pricing formula and are highly theoretical. At the time of expiry, Berkshire's actual cash obligation may be significantly greater or less than the liability currently presented on their balance sheet or the current intrinsic value.
Value of Holding Company Liabilities:
Holding Company Debt: $13.4 billion
Credit Default & Equity Index Options: $10.5 billion
Total Value: $23.9 billion
Value per Class B Share: $9.50
Operating Businesses: $133 billion/ $54 per Class B Share
After-Tax Liquidation Value of Investment Portfolio: $123 billion/ $50 per class B share
Excess Cash: $31 billion/ $12.50 per Class B Share
Insurance Underwriting/Float Liability: $0
Holding Company Liabilities: $24 billion / $9.50 per Class B Share
Aggregate Value: $263 billion / $107 per Class B Share
Alternate Valuation Methodologies:
Here the author will discuss the projected earnings power of Berkshire on a non-GAAP basis. The author uses his own earnings estimates for operating businesses in conjunction with 2013 consensus estimates for Berkshire's equity holdings.
Per GAAP accounting requirements, Berkshire does not consolidate its undistributed proportional earnings of equity investments on the income statement. This can make Berkshire appear expensive on reported earnings. As discussed earlier, the author derives total proportional equity earnings of $6.9 billion, with retained earnings of $4.6 billion and dividends of $2.3 billion.
There is an important tax consideration to keep in mind when considering Berkshire's equity earnings. This issue arises from the differing tax treatment that Berkshire receives on dividends versus equity appreciation. To avoid triple taxation, the IRS allows for a "dividends received deduction" for corporations that receive dividends on non-debt financed equity ownership stakes in other corporations. However, when the unrealized value of Berkshire's equity securities increases, they record a deferred tax liability equal to 35% of the gain. These gains would convert to a cash tax liability of an equal amount if gains were realized. Therefore, if Berkshire realizes the entire value of its investment through dividends, its tax obligation will be significantly lower than if it were to realize value from selling securities at a gain. As Berkshire has historically maintained equity investments for a long period, the author feels the greater portion of value will be extracted via dividends rather than realized gains. For this reason, the author taxes equity earnings at the dividend rate of 10.5%. The author realizes there is no "clean" answer to this dilemma and encourages the reader to use their own best judgment.
The table below presents Berkshire's 2013 projected earnings. All estimates are net of interest and tax including underwriting income, investment income, and holding company interest expense.
2013 Projected After-Tax Earnings ($ billions):
BNSF: $3.9 billion
Manufacturing, Service & Retailing: $4.2
Finance & Financial Products: $.65
Underwriting Profit: $1.1
Proportional Share of Equity Earnings: $6.2
Investment Income from Fixed and Hybrid Securities: $1.8
Interest on Holding Company Debt: ($.28)
Total Earnings: $18.92 billion
Earnings per Class B Share: $7.65
To infer the Company's current price to earnings ratio the author deducts the excess cash and an estimated warrant value of $4 billion from the market cap while adding back the equity index option liability. At $87 per Class B share Berkshire has market capitalization of $215 billion.
Adjusted Market Capitalization =
Market Cap - Cash - Estimated Warrant Value + Equity Index Option Liability
= 215 - 3 -4 +10.5 = 190.5 billion = $76.87 Adjusted Price per Class B share.
Implied Adjusted Price to Earnings = 76.87/7.65 = 10x.
If one applies a multiple of 13x ( 2013 S&P earnings multiple) to Berkshire's estimated earnings and adds back the $24.5 billion in adjustments, the implied valuation is $110 per Class B Share.
Per Share Value of Earnings: 7.65*13 = $100
Excess Cash: $31 billion
Warrants: $4 billion
Option Liabilities: $10.5 billion
Value of Non-Earning Asset and Liability Adjustment: $24.5 billion/ $10 per Class B Share
Total Value: $110 per Class B Share
Book Value Approach
Berkshire has total assets of $424 billion, liabilities of $235 billion with shareholders' equity net to Berkshire of $184.6 billion. Using the previously calculated 2013 earnings, this equates to an ROA of 4.45% and a ROE of 10.23%
It is interesting to note Berkshire is typically compared to banks and insurance companies on a price to book basis. This comparison appears somewhat invalid as: Berkshire's assets appear far more efficient and (ii) aggregate leverage is significantly lower. For instance, Wells Fargo, the most efficient of America's large financial institutions, generated a ROA of 1.45% and ROE of 13.38% in the third quarter of 2012. The implication being that Wells needs to employ over 3x the leverage of Berkshire to generate equivalent returns. Conversely, Berkshire's ROE would be above 30% if they applied similar leverage.
Berkshire's superlative asset productivity stems from several components. First, Berkshire's operating businesses produce a significantly higher return on assets relative to most financial companies. Second, Berkshire has a greater percentage of higher yielding equity & hybrid securities than the debt and mortgages typically held by banks and insurance companies. Finally, Berkshire funds their assets on an extremely inexpensive basis. Only $62.5 of Berkshire's $235 billion in liabilities is in the form of debt with the rest comprised of zero cost float, deferred taxes, derivatives, and accounts payable.
For valuation purposes, the author feels that it is instructive to look at Berkshire's price-to-book multiple relative to its return on equity as a mechanism to determine the cost of capital that investors are charging to hold the stock.
Book Value * (ROE/Cost of Equity) = Value of Equity;
Value of Equity/Book Value = ROE / Cost of Equity
Solving for Berkshire:
215/185 = 10.23%/Cost of Equity
Cost of Equity = 10.23%/1.16 = 8.8%
185*(10.23%/8.8%) = $215 Billion
Hence, at the current price-to-book multiple of 1.16x, investors are demanding an 8.8% return to hold the stock. If we take the inverse of the 2013 S&P multiple of 13x, 7.7%, as a proxy for the broader market's current cost of equity capital, it appears the market is charging a 1.1% premium to hold Berkshire's equity. The author views this premium as unjustified given Berkshire's predictable earnings streams, conservative capitalization, and elevated returns on incremental capital. At a 7.7% cost of equity capital, Berkshire's equity has a value of $246 billion, or $100 per class B Share.
As with the sum-of-the-parts and earnings valuations, the author feels it is important to make an adjustment for excess cash - which contributes nothing to the return (numerator) portion of ROE but is included in the equity portion (denominator). For instance, if Berkshire used their current $31 billion excess cash position to purchase $2 billion in net income, ROE would increase from 10.2% to 11.3%. If the stock price did not appreciate upon this acquisition, market participants would be charging a 2% annual return premium to hold Berkshire relative to the broader market. This appears even more irrational.
Using a cash-adjusted ROE of 11.3% with a market cost of equity capital of 7.7% implies a price-to-book multiple of 1.46x. This is slightly below Berkshire's historical average of 1.5x. This equates to a market capitalization of $270 billion, or $110 per Class B Share. The author feels that this is a prudent and conservative way to calculate Berkshire's equity value and makes sense within the context of Berkshire's historical valuation range.
It is the author's hope that this paper has demonstrated that through a variety of valuation techniques a rough depiction of Berkshire's intrinsic value can be sketched out. Undoubtedly, important facts have been omitted and estimates about future performance are incorrect to some extent. Therefore, the author encourages investors to do their own work before allocating capital.