I am constantly on the lookout for undervalued stocks of great companies with a strong and durable competitive advantage. However, during the past three or four months it has become extremely difficult to find a good company that isn't already overvalued or fair priced.
Having said that, you can easily understand how happy I was when I checked out the recently released 10-Q of Warren Buffett's Berkshire Hathaway (BRK.A, BRK.B) for Q1 of 2013. It seems that Berkshire at its current valuation is a company that offers limited downside risk and decent upside potential.
As of March 31st Berkshire Hathaway had book value of $82 per share. In the last annual letter from Mr. Buffett sent to Berkshire's shareholders he made it clear that he is willing to buy back Berkshire stock up to 120% of its book value. This was also repeated in the company's latest 10-Q. That puts a valuation "floor" for the stock price around $98 per share. That's just 9% below Berkshire's current stock price of $108.64.
Despite the fact that we don't know if or when Mr. Buffett will buy back stock, this "price floor" gives us a clear message that at this level he deems Berkshire is undervalued enough for him to buy as if it was some other company with the traits he likes to see. Given that there is no one that knows Berkshire Hathaway better than him, I believe that we can trust his assessment to be a good one.
Berkshire's upside is based on two factors, a qualitative and a quantitative. The qualitative is that Berkshire is a big collection of businesses that have one thing in common, strong and durable competitive advantages. From Burlington Northern to the Omaha World Herald Berkshire's businesses have some kind of protection against competitors that allows them to enjoy superior returns on their assets even in times of recession or worse.
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The main driver of Berkshire for the last few years in my opinion has been the operating companies that it owns, not its investment returns. And this I believe will continue to be true in the future as Berkshire is growing and becomes too big to just buy pieces of businesses in the stock market.
Given the average 17% growth rate of Berkshire's net operating profits, the company should be broken in two pieces in order to be valued correctly. The operating segment according to DCF valuation is worth approximately $117 in a ten-year horizon. To calculate that I assume a 17% growth rate, 5% discount rate and operating EPS of $6.14 for 2013.
Furthermore, I expect the company to continue making good to great investment decisions even after Mr. Buffett is gone. Todd Combs and Ted Weschler have proven to be two excellent choices as Berkshire's CIOs and given their value approach to investing I expect them to continue to be so. I expect the investment side to contribute around $2 to $3 EPS on average every year during the next decade adding $20 to $30 in Berkshire's current fair value.
Summing up, Berkshire Hathaway's value lies somewhere between $137 to $147 per share, offering 26% to 35% of potential upside for prospective investors. Add to that the limited downside of just 9% and it becomes instantly clear just how good an investment Berkshire Hathaway is.