When I tell people I own Berkshire Hathaway (BRK.B) (BRK.A), the most common pushback I get is "Warren Buffett won't live forever." This is hard to argue with. The only person with a better record than Buffett is Father Time. However, what I can argue, and I think convincingly, is that Berkshire Hathaway does not contain any "Buffett Premium" at prevailing prices. In fact, I would argue that Berkshire trades at a discount to the broader market despite having several advantages that the average company does not - exclusive of Buffett's capital allocation acumen.
By my calculation, Berkshire will generate approximately $29 billion in pre-tax income this year (calculation presented below). At $117 per Class B share, or $288 billion in market capitalization, that equates to a pre-tax yield of 10%. The S&P 500 is estimated to earn $111 in after-tax earnings this year. At an average tax rate of 35%, this equates to a pre-tax earnings of $170, or a 10% yield at S&P 1700. Therefore, it appears that Berkshire and the S&P trade at equivalent yields. This should disprove the "Buffett Premium" argument. Furthermore, I would argue that Berkshire trades at a discount to the broader market when adjusted for the following:
- Berkshire held $35 billion of cash at the end of 2nd quarter. This cash earns nothing but can be used to purchase earnings going forward. For instance, if Berkshire deploys $15 billion of this cash at a 10% pre-tax yield (maintaining the self-imposed $20 billion minimum withholding requirement), this would add an additional $1.5 billion in pre-tax earnings.
- Berkshire has significant in-the-money warrant positions that do not currently generate income, but give Berkshire the option on significant future earnings streams. For instance, using current estimates, if Berkshire converted all warrants in BAC, GS, and GE, their proportional share of pre-tax earnings would be $1.5 billion. (Pre-tax to Berkshire, after tax to investee)
- Berkshire has $22.6 billion in preferred stock with an average yield of 8.4%. Berkshire holds these securities at cost. However, if these securities traded in the open market, they would like trade at a huge premium to par, e.g. $4.4 billion of Wrigley subordinated notes at 11.45% yield or $8 billion of HNZ preferred at 10% yield-to-call. Therefore, Berkshire's earnings from preferred securities should be capitalized at a much lower rate than broader S&P earnings. The same should be said from Berkshire's earnings from fixed maturity securities.
- The quality of Berkshire's equity holdings and operating business appear to be of broadly higher quality than the S&P 500. For instance, over half of Berkshire's pre-tax operating earnings, excluding insurance operations, will come from railroads and utilities. Railroad and utility companies trade at a significant premium to the overall market.
- The earnings from equity investments are presented after the respective company pays taxes but before Berkshire pays taxes on those earnings. To avoid triple taxation, the IRS allows for a dividend received deduction on dividend equating to 70%. Therefore, if Berkshire extracts value from its equity holding in the form of dividends rather than realized gains, Berkshire's effective tax rate will approximate 10% vs. 35%.
- Following from this, Berkshire has a deferred tax liability of $50 billion, meaning that Berkshire's cash tax rate has been significantly below its GAAP tax rate over time. As long as Berkshire does not realize gains and its operating businesses make qualifying purchase of PP&E, Berkshire is essentially getting a perpetual zero-interest loan. Therefore, the present value of Berkshire's deferred tax liability is likely overstated to a significant extent.
To summarize, Berkshire holds significant assets that do not currently generate earnings but give Berkshire optionality on significant earnings streams going forward (cash and warrants). Furthermore, Berkshire's earnings are of generally higher quality than the S&P with a significant portion coming from bonds, preferred stocks, and stable railroad and utility businesses.
For my purposes, I add $1.5 billion to Berkshire's pre-tax earnings to account for the option value of excess cash that Berkshire holds. This gets me to $31.5 billion pre-tax. Additionally, I capitalize Berkshire's earnings 1% below the S&P 500 to account for 1) undervalued assets on the balance sheet 2) earnings optionality from warrants 3) the generally higher quality of operating earnings 4) Berkshire's "fortress" balance sheet 5) the overstated impact of GAAP tax on actual cash earnings.
Adjusted Pre-Tax earnings: $31.5 billion
Capitalization Rate: 9%
Total Value: $350 billion
Value per Class B Share: $142
Admittedly, this is a somewhat nebulous exercise, but so is security analysis. I guess the larger point here is that I am pretty comfortable that I am buying a high-quality security at a reasonable discount to its intrinsic value, which for me, is what good investing is all about. Therefore, although I hope Buffett continues to operate Berkshire as long as he is able, I do not believe I am overpaying for the privilege of owning the Company even if he were to exit tomorrow.
- Most of the data comes from the most recent 10-Q and 13-F filings. 13-F 10-Q
- Operating business and insurance operations are my own
- Equity holdings EPS estimates come from MSN Money - current as of August 8th, 2013. S&P Earnings estimates come from Yardeni Research which can be found from Googling "S&P 500 Earnings Estimates Yardeni".
- I assume that securities not listed on their most recent 13-F earn a 6% yield
- HNZ common stock is listed in the "Preferred Stock" bucket. I assume it will earn a 7% pre-tax yield. I also annualize its earnings although Berkshire will only own it for 2nd half of year. I think this is fair as Berkshire has already made the cash outlay to acquire HNZ.
- I do not account for the impending NVE acquisition - either in earnings or cash outlay
- Estimated underwriting income may be high as we have not entered hurricane season. Implicit in this assumption is no major catastrophes for the balance of the year. This is probably a foolish assumption.
|US Equities||Shrs. Owned||2013 CY. EPS Est.||Net to Berkshire ($ Millions)|
|2Q Ending Value of Domestic Equities (Millions)||86,702|
|2Q 10-Q Value of Total Equity Securities||103,274|
|Implied Value of Foreign and 2Q Purchased Equities||16,572|
|Estimated Yield of Foreign and Purchased Equities||6%|
|Total Equity Earnings||7,458|
|Preferred Stock||Notional Amount||Coupon||Interest Income ($ Millions)|
|Wrigley Subordinated Notes||4,400,000,000||11.45%||504|
|Wrigley Pref. Stock||2,100,000,000||5%||105|
|Wrigley Senior Notes (Estimated)||100,000,000||5%||5|
|HNZ Pref. Stock||8,000,000,000||9%||720|
|HNZ Common Stock (Estimated Annualized)||4,200,000,000||7%||294|
|Fixed Income||Notional Amount||Coupon (estimated)||Interest Income ($ Millions)|
|Non-Insur. Operating||2013 Est. Pre-tax Earnings|
|Manu., Serv & Retailing||6,520|
|Finc. & Fincl. Products||856|
|Insurance Underwriting||2013 Est. Pre-tax Earnings|
|Totals||2013 Est. Pre-Tax Earnings|
|Fixed Maturity Securities||1,089|
|Manu., Serv & Retailing||6,520|
|Finc. & Fincl. Products||856|
|Corporate Int. Expense||(296)|
|Class B Shares Outstanding||2464.5|
|Current Px||$ 117.00|
|Berkshire BTAX Equity Yield||10.08%|
|Estimated S&P 500 2013 EPS||$ 111.00|
|ATAX Equity Yield||6.53%|
|Assume 35% Tax Rate||35%|
|S&P 500 BTAX Yield||10.05%|